The central bank on Tuesday raised interest rates for the first time in nearly three years in an attempt to combat inflation and soak up excessive market liquidity.

The People's Bank of China said it was raising benchmark rates by 25 basis points, taking one-year deposit rates to 2.5 percent and one-year lending rates to 5.56 percent, effective on Wednesday.

The move reflects the government's resolve to take further measures to cool the property market and curb persistent inflation, economists said.

China's inflation accelerated to 3.5 percent in August, the highest level in 22 months, underscoring the necessity for further government measures.

"The move is reasonable, as inflation has been above the warning line of 2.25 percent for quite a long time, and is expected to hover at a high level in the coming months," said Zhu Baoliang, deputy director of the economic projection department at the State Information Center.

"It signals the central bank is tightening controls over inflation. But I don't expect any major interest rate hike to come for the rest of the year, as it may dampen economic growth," Zhu said.

The impact of the rate hike was immediately felt by global markets. Oil prices fell, stock markets turned negative in Europe and the dollar rose as investors were caught off guard.

"The interest rate rise is entirely outside market expectations," said Zhu Jiangfang, chief economist at CITIC Securities in Beijing.

"The recent rise in headline inflation has put the real rate into negative territory. And I think that's why the central bank needs to raise interest rates in such a hasty way," he said.

Zhang Xiaojing, senior economist at the Chinese Academy of Social Sciences (CASS), said raising interest rates is a market-based tool that the central bank used to absorb excessive market liquidity, as unprecedented lending over the past two years pushed up asset prices, especially the price of property.

Major banks were already ordered last week to increase reserves in a move to shrink the pool of money for lending.

Housing prices in China's 70 major cities rose by 0.5 percent on a monthly basis in September, rebounding for the first time since the country rolled out a batch of measures to clamp down on the real estate market in April.

"As the earlier administrative tightening measures did not work well, the interest rate hike will help curb speculative property investments and home purchases," Zhang said.

Others worried that the rate hike will dampen market sentiment, after the Shanghai stock index, a laggard for much of this year, jumped nearly 16 percent in the past nine trading days.

"This is a bucket of cold water for the market," said Zhang Yuheng, an analyst with Capital Securities in Shanghai.

"The hike itself is not a big one, but the psychological impact is big," as expectations will grow for more rate hikes, he added.

China is due to release its third-quarter macroeconomic data on Thursday and analysts said the timing of the hike might suggest that the figure is likely to be better than expected.

"It signals that Chinese policymakers have become more confident on the economy, especially regarding the strengthening momentum for domestic demand," Wang Qian, chief China economist at JP Morgan, said.

"We have been highlighting that the Chinese economy bottomed by the second quarter, and growth will pick up, steadily going ahead as local governments gear up to start new projects early next year," Wang said in a research note.

Zhang of the CASS said the rate hike reflects a shift on focus.

"The move shows that the foundation for growth is firm, and the policy focus has shifted from concerns over an economic slump to worries about economic overheating."

(China Daily October 20, 2010)