China's leaders view inflation with a special dread. Rising prices helped stir the Tiananmen Square protests of 1989, almost costing the Communist Party its monopoly on power. As much as they may chafe under restrictions on freedom of speech or political activity, the Chinese seem far more likely to turn against the regime over the price of a cut of pork or bag of rice.

Why, then, has Beijing reacted so mildly to this year's run-up in consumer prices? Inflation is at its highest levels in a decade, hitting a peak of 8.7 per cent in February before declining to 7.7 per cent in May. The price of basic foodstuffs, particularly the Chinese staple, pork, went up especially sharply. Then there is the price of oil, which filters through to almost everything. The usual response would be to raise interest rates or allow China's currency to float much higher against international counterparts. But those measures would probably cause economic growth to slow, undermining the implicit guarantee of continued, rapid progress that helps keep the party in power. China thus finds itself on the horns of a dilemma. Put the brakes on the economy and suffer the resulting public discontent or keep pressing the gas pedal and suffer the pain of inflation.

In fact, the problem is worse than that. China's leaders have fashioned for themselves a grand trap. China's economy thrives because it has become the workshop of the modern world, flooding the globe with its manufactures. Those exports produce a huge trade surplus and a tidal inflow of foreign exchange. As dollars and other currencies flood into China to pay for what it makes, China must issue new Chinese currency to purchase them.

One result is a pile of foreign exchange reserves: a staggering $1.81-trillion worth by the end of June. The other is excess liquidity as all that money sloshes around the bilges of the monetary system. That money has overflowed into stocks, real estate, art and other investment vehicles, causing their prices to balloon (then, often, pop). Inevitably, it drives up consumer prices too.

What to do? Beijing has been under overseas pressure for years to ease the loose peg of the yuan to the U.S. dollar and allow its value to rise. Though the yuan has indeed risen 16 per cent against the greenback since 2005, Beijing has been reluctant to go further, fearing that a big run-up in the currency would hobble economic growth by making Chinese goods more expensive for foreigners to purchase. It hesitates to raise interest rates, too, knowing the dampening effect it would have on the domestic economy, with all the attendant risks of public unrest. Its reluctance has grown as U.S. interest rates have fallen, opening up a big gap between U.S. and Chinese rates and encouraging a surge of "hot money" to flow into China in search of higher returns. One estimate puts the amount that has come in during the first five months of the year at more than $150-billion. Beijing doesn't like to think what might happen if that money suddenly fled.

These fears are real enough. China is still a poor country and its further advance depends on rapid economic growth. No one likes to contemplate squeezing inflation out of the system by manufacturing a recession, as a developed country might have the luxury of doing. But would a drop of two or three percentage points really be the end of the world in a country whose economy is still growing at more than 10 per cent a year? Wouldn't runaway inflation pose an even greater threat to the country and the regime that rules it?

Beijing would be wise to act against inflation while the economy is healthy and it still has the room to act.

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