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China on Alert as Inflation Creeps Up

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After a year of benign inflation consumer prices are ticking up in China amid an uneven economic recovery, posing a dilemma for policymakers.

The country's consumer price index (CPI) rose to a higher-than-expected 3.2 percent in February from a year earlier, compared with 2 percent in January, raising the question whether the People's Bank of China (PBOC) will tighten monetary policy in the near-term to control inflation, or focus on supporting growth.

Data released over the weekend, including industrial production and retail sales for February came in below analyst forecasts, highlighting softness in China's economic recovery.

(Read More: China's Latest Data Show Uneven Economic Recovery )

"A slow recovery, coupled with higher than expected inflation and returning capital inflows, leads to a tougher call for China's policy tone," wrote Tommy Xie Dongming, economist, treasury research & strategy at OCBC.

While a rise in food prices, driven by the Lunar New Year holidays last month, contributed to a jump in inflation, non-food price inflation in the combined January and February period was higher than its historical average, according to Nomura, indicating that inflation has become broad based.

And economists forecast that the pace of inflation will stay high for the rest of the year given rising labor costs and abundant liquidity. Commerce Minister Chen Deming warned the country is also at risk of importing inflation from higher commodity prices as a result of the competitive devaluation of major currencies.

(Read More: China Warns Over Fresh Currency Tensions)

Citi, for example, estimates average inflation may top 3.5 percent in the fourth quarter of this year. Last week, the Chinese government lowered its inflation target for 2013 to 3.5 percent from 4 percent for the previous year. Average inflation in 2012 came in below target at 2.6 percent.

Yifan Hu, chief economist at Haitong International Research believes monetary policy in the mainland will remain accommodative through the first half of the year, because "the current state of China's domestic economy has not recovered a high level of dynamism yet."

The central bank will likely wait until the second half of 2013 to hike the official lending rate, according to economist predictions. In 2012, the PBOC cut interest rates twice, in June and July, to boost growth.

"Chinese CPI rose quite sharply. We are not changing our view that the implication will be monetary tightening (but) we are keeping the second-half 2013 time horizon because only by then price pressures will be strong enough to warrant action," said Dariusz Kowalczyk, senior economist, Asia ex-Japan at Credit Agricole, who expects two rate cuts in the second-half.

In the meantime, the PBOC is likely to focus on draining liquidity in the second quarter through open market operations, Kowalczyk added.

The central bank has begun withdrawing liquidity in recent weeks, draining a net 253 billion yuan ($40.6 billion) from the banking system through its open market operations in February, according to Reuters.

By CNBC's Ansuya Harjani