A policy adviser to the People's Bank of China told Reuters the authority may tighten cash conditions in the financial system to address the inflation risks, while the central bank refrained from supplying cash to money markets for the second day running.

If it also avoids injecting cash at its next money market operation on Thursday, the effect will be a net weekly drain of 58 billion yuan — the second biggest since February.

"(Policy) will only be tightened slightly as inflation is rising. There are some concerns on bank lending," said Song Guoqing, an academic member of the central bank's monetary policy committee.

"Policy fine-tuning will rely mainly on open market operations and I cannot see any possibility of changing interest rates or bank reserve ratios."

Song's comments and the sharp rise in house prices highlight Beijing's policy quandary.

On the one hand, policymakers want to avoid a buildup of market and economic imbalances, such as a debt-fueled property bubble.

On the other hand, they are reluctant to use more potent instruments to control the imbalances in case they also blunt a modest economic recovery ahead of a crucial policy meeting next month.

China's house prices in September rose 9.1 percent from a year earlier, the sharpest rise since January 2011, calculations of official data by Reuters shows. The CSI300 of leading Shanghai and Shenzhen A-share listings fell 1 percent as investors braced for possible measures to calm the property market.

Song said consumer inflation rather than property prices served as the central bank's key policy signpost. Money market traders said they would wait until Thursday's money market operation to conclude whether the central bank was trying to send a policy signal given that short-term rates have fallen sharply since the end of the third quarter.

The weighted-average benchmark seven-day repo rate has dropped nearly a full percentage point over the last eight trading sessions.

Traders and economists believe current ample funding conditions in the financial system reflect in part official efforts to prop up economic growth and an effort by the central bank to make amends after it engineered a credit crunch in the interbank market in late June.

That move was widely seen as a warning to banks to rein in riskier lending, but the central bank appeared to have been admonished by the central government for the opaque way in which the cash squeeze was managed.

Now, however, economists believe the PBOC may have gone too far in the other direction.

SOLUTIONS

China's economy grew at its fastest clip this year in the third quarter fueled largely by investment, but signs are emerging that resurgent credit growth might drive up inflation even as the recovery runs into fresh headwinds.

Consumer price inflation rose to a seven-month high of 3.1 percent in September from 2.6 percent in August, data showed last week. Tuesday's house price data from 70 major Chinese cities offered more evidence of price pressures.

Song, however, saw little risk of inflation getting out of hand given steady demand and limited potential for a pick up in economic expansion as Beijing tries to gear the country more to consumer-led growth.

The adviser predicted policy fine-tuning would be sufficient to stabilize inflation at the current level in the fourth quarter and so keep the full-year rate comfortably below the government target of 3.5 percent.

Economic growth could ease to 7.5 percent in the fourth quarter from 7.8 percent in the third quarter, he said. But full-year growth could still come in at 7.6 percent, just above Beijing's 7.5 percent target, he added.

"A slowdown in growth in the fourth quarter would probably reawaken fears of a hard landing but we would welcome it," wrote Mark Williams and Julian Evans-Pritchard of Capital Economics in a research note.

"A prolonged surge in credit-fueled investment is the last thing China now needs."

Chinese banks made 787 billion yuan ($129 billion) of new yuan loans in September, higher than a forecast of 650 billion yuan and more than August's 711.3 billion yuan, central bank data showed.

At the same time, yuan has poured into the economy as a side effect of massive intervention by the central bank intended to curb the strength of a long-running rally in the local currency.

With the central bank seen as reluctant to use interest rates to rein in property prices, markets will shift their focus to the ruling Communist Party's key policy meeting in November, when the leaders are expected to map out how to shape the economy in the coming decade.

"With the issue in the property market becoming more and more severe, the third plenum next month should touch upon the problem," said Wang Jun, a researcher at the China Center for International Economic Exchanges (CCIEE), a government think-tank.

Securing more land for development to cool the red-hot market is one option under debate. Another is to use property taxes to rein in demand.

What complicates the policy response is a divergence in house price inflation between big and small centers.

The figures from the National Bureau of Statistics showed house prices in the country's largest cities continued to rise much faster than the national average. They were up 16 percent in Beijing, 17 percent in Shanghai and about 20 percent in the southern cities of Guangzhou and Shenzhen.