Controlling inflation is now the government's main policy challenge. In November year-on-year consumer price inflation reached 5.1%, its highest level since July 2008. The recent acceleration in inflation is being driven by higher food prices, which are largely a result of unusual weather patterns in parts of China. More worryingly, core inflation has also started to creep up in recent months. We estimate average inflation at 3.3% in 2010 and forecast that the rate of price increases will remain elevated during the first half of 2011. Strong liquidity growth and booming demand (which has helped to eliminate the output gap that appeared during the 2008-09 downturn) are other factors contributing to the recent sharp rise in inflation. Headline inflation will average a manageable 4% in 2011-15.

However, the risks to our forecast remain largely on the upside. The main danger concerns the volatility of food prices (which account for a large share of the consumer price index basket in China). Local agricultural prices are vulnerable to the vagaries of the weather-particularly in China, but also internationally. In any case, food prices will rise as agricultural land becomes scarcer and the cost of other farming inputs increases. Another risk is that if economic growth were to strengthen unexpectedly, this might eliminate excess capacity from product markets, enhancing companies' ability to raise prices. In addition, the large salary increases that firms are having to offer to keep workers-and, in some cases, to end industrial disputes-may put upward pressure on consumer prices as well as raising manufacturing costs.

Producer prices have increased sharply in 2010 as a result of strong domestic demand, recovering global prices for raw materials and policy-driven increases in state-mandated prices for fuel and utilities. Producer price inflation will cool in 2011-15 owing to greater stability in international oil and commodity prices. There is a danger that speculative asset price bubbles, notably in property or equity markets, could emerge in the forecast period. The risk is aggravated by negative real deposit interest rates, which encourage savers to put their money in other saving and investment vehicles.