Over the past few months policymakers in China have been confronted with a ticklish dilemma: how to maintain rapid growth in an economy facing slowing external demand without pumping up domestic inflation. For most of this year the problem didn't exist. Growth was ticking along famously at an annual rate well over 9 per cent. The challenge was rather how best to contain inflation and subdue fast-rising property prices. In most countries, the natural response would have been to raise interest rates. But with a continuing programme of state infrastructure investment to fund, Beijing was reluctant to raise borrowing costs. So instead the authorities kept interest rates low and introduced a range of quantitative tightening measures while imposing administrative restrictions on the property market. Banks were told to ration credit, and ordered to set aside more of their deposits as reserves. At the same time, the authorities made it tougher for would-be property buyers to get mortgages and slapped a ban on multiple purchases. By and large the measures seem to be working. Although the imposition of quotas on formal loans prompted China's banks to increase their informal off-balance-sheet lending, credit still became a lot harder to obtain, especially for the private sector. But money supply growth slowed abruptly, falling from a dangerously overheated 29.7 per cent in November 2009 to a tight 12.9 per cent in October (see the first chart). Inflation peaked at 6.5 per cent in July, abating to 5.5 per cent now. The property market cooled off too, with transaction volumes dropping steeply and prices beginning to ease. But just as the authorities' anti-inflation efforts appear to be paying off, policymakers find themselves facing another problem: a slowdown in the developed world which means weaker demand for China's exports, and by extension threatens millions of jobs in the manufacturing sector. At this point the conventional response in other markets might be to ease monetary policy by cutting interest rates. But that's not an option for Beijing. Because the authorities were so reluctant to raise rates in the first place, the deposit rate today is significantly below the rate of inflation. Cutting interest rates now would merely accelerate the flow of savers' funds from the banking system, making it harder, not easier, for banks to lend. In any case, policymakers are not yet convinced that they have beaten inflation. Although the rate of consumer price rises has eased, there is still a large monetary overhang left in the economy following 2009's lending binge. At 175 per cent, the ratio of M2 money supply to gross domestic product looks uncomfortably high compared to an average of 160 per cent over the five years preceding the crisis (see the second chart), implying that there is still plenty of latent inflation pressure in the system. Any broad-based easing of either interest rates or lending restrictions now could simply re-ignite consumer price rises. Yet with activity softening, industrial production slowing and many companies feeling the pinch, the authorities have to do something to protect jobs. Their answer is 'selective easing'. Beijing has ordered the banking sector to step up lending to low-cost housing and infrastructure projects as well as to credit-starved smaller companies. New bank loans duly jumped 25 per cent last month compared with September, with much of the increase consisting of medium- and long-term loans to corporations. At the same time, the government is instituting value-added tax reforms which should reduce the tax burden for smaller companies. In addition, over the past few months the central bank has steered interbank interest rates slightly lower and slowed the yuan's rate of appreciation against the US dollar, which should help ease the pressure on exporters. So far these are cautious steps, but no doubt the authorities stand ready to introduce more selective easing should conditions deteriorate further. Whether this unconventional approach will achieve its desired result of supporting employment without fuelling inflation remains to be seen. But considering that Beijing's earlier unconventional tightening measures appeared to do the trick, you have to reckon that selective easing stands a fair chance of working too.