ECONOMYNEXT – Sri Lanka’s inflation target of 5 percent, which has been set by the central bank based on its own past performance could be revised in the future, Deputy Minister of Economic Development Anil Jayantha Fernando said.
The central bank has set the inflation target based on the inflation it has created in the recent past, where Sri Lanka’s average inflation has been around 5 percent, he explained.
“In the future if it is not appropriate, we can accordingly change,” Minister Fernando told parliament.
The current three-year inflation agreement signed with the government runs out in 2026, he said.
Minister Fernando was replying to a question by opposition legislator Ravi Karunanayake.
The central bank has missed its 5 percent inflation target, which is sometimes seen as deflation when 12-month data is taken into account, but prices have moved up marginally since 2022.
There was no problem in having lower than targeted inflation, Minister Fernando said.
“A period of lower inflation than the targeted inflation could provide some relief to households and businesses,” Minister Fernando said.
Critics have pointed out that under cover of the 5 percent inflation target the central bank triggered back-to-back currency crises since the end of a 30-year war in 2012, 2015/16, 2018 and 2020/20 collapsing the rupee from 113 to 360 to the US dollar.
The collapsing currency led to higher food and other prices, destroying real wages leading to elected governments being turfed out of office by an angry public.
Destroying real wages and any delay in raising energy or water prices, gives a short-term cost benefit to exporters at the expense of social unrest and busted public finances through SOE losses.
Under the current leadership, under broadly deflationary policy, the rupee was allowed to appreciate to around 300 to the US dollar.
In 2018 money was printed for ‘flexible inflation targeting’ despite taxes being raised by then Finance Minister Mangala Samaraweera, and fuel being market priced, triggering forex shortages.
Budget with zero inflationary financing but inflation target 5-pct
In February 2025, presenting a budget, Minister Fernando said they had maintained spending and planned to raise all money for spending and debt repayment through real borrowings and not inflationary means.
“We have not moved to fill this gap with inflationary ways or money printing,” Minister Jayantha told parliament in February 2025.
“We are planning to raise 2,125 domestically through non-inflationary means. Foreign financing is 75 million dollars.”
Sri Lanka’s high inflation, which started to move above that of the US from the early 1980s, comes from badly anchored money and critics say using statistics and rejecting economics to come to a 5 percent target does not make sense.
Sri Lanka has exchange controls, indicating that the central bank in any case has a flawed operating framework, which violates very basic economic principles described by economists including Hume, Ricardo and Smith.
In any case, after targeting ‘mid-single digit’ inflation for years to claim that Sri Lanka’s inflation is or should be 5 percent is a circular argument, analysts say.
It is not clear why an ‘independent’ central bank is needed to create 5 percent inflation a year or depreciate the currency for ‘competitive exchange rates’ to support one section of economic players against the public interest.
Inflation Craze
Macro-economists, especially from the US, deliberately started to create peacetime inflation in the 1960s after statistically claiming that there was a trade off between inflation and employment, suddenly rejecting 200 years of classical economics.
Full employment policies then led to rapid fire peacetime economic crises.
As a direct result the Bretton Woods collapsed in 1971 leaving central banks without a credible anchor, with commodity prices shooting up from 1974 in particular after the collapse of the interim Smithsonian agreement.
Macro-economists then started to claim that inflation was fully or partly supply driven (Arab oil embargo, unions or wage spiral inflation, cost push) leading to wrong remedies (incomes policies) that led to the Great Inflation in 1970s as floating exchange rates were operated without a credible anchor.
In the late 1970s the US and UK started to actively target money supply as an alternative anchor to gold (taking leaf off the Bundesbank which was targeting 6-9 percent broad money) and succeeded in ending Great Inflation.
Analysts say Germany had a basic form of inflation targeting where it stopped targeting money supply as soon as inflation fell, whereas the US initially targeted the money supply and then bank reserves allowing rates to go very high as a consequence.
In the 1960s the Bundesbank targeted credit and also appreciated the currency to ward off 1960s full-employment-policy inflation from the US dollar coming through the Bretton Woods system.
In the US the so-called employment mandate was rejected by Fed Chief Paul Volker and in the UK political authorities took control of the Bank of England and forced it to tighten monetary policy from 1979.
Monetary Anchor for Floating Regimes
In 1990 New Zealand started what is now called inflation targeting for floating exchange rates, setting a target of 0-2 percent based on classical principles that sound money was needed for a society to operate.
The 2 percent was not a target to generate inflation but a ceiling. It was later widened to 0 to 3 percent.
In the years before the 0-3 percent target – which was reached fairly quickly – inflation in New Zealand was around 15 percent, partly due to a collapsing currency in the 1980s like in Sri Lanka.
The most successful East Asian countries piggybacked on the US stability targeting the exchange rate as under the Bretton Woods in the 1980s. In the 1970s, Japan, Taiwan and Singapore appreciated their currencies to ward off Great Inflation created by the Fed due to its un-anchored floating rate.
Sri Lanka’s central bank has run exceptional monetary policy from around September 2022 to the last quarter of 2024.
However, analysts have warned that with rate cuts and reduced deflationary policy (there is no QPC to sell down the central bank’s domestic assets in the current IMF program though coupons are deflationary) Sri Lanka risks a slide back.
Any attempt by the central bank to collect reserves without deflationary policy will lead to depreciation and social unrest, analysts have warned. Collecting reserves and targeting inflation (which needs a floating rate) leads to anchor conflicts.
Better than the US
Sri Lanka had a currency board (no policy rate) until 1950 but in the first year to 18 months of the central bank’s existence under then Chairman John Exter it operated active deflationary policy, to try and stop inflation coming from the US due to money printed by the Fed to buy Liberty Bonds.
Currency appreciation as Japan and Singapore did later was also considered but ruled out.
The Ceylon central bank raised reserve ratios to 14 percent from 10 percent mopping up some of the liquidity from dollar purchases and also urged banks not to convert dollar deposits to rupees.
The Fed stopped its World War II obligation to buy bonds and support their prices under the Fed Treasury Accord and returned to a ‘bills only’ policy, to allow it to keep zero inflation and the gold standard, which was described as central bank independence.
From 1952 the central bank sterilized the balance of payments in the opposite direction by engaging in open market operations to support government securities prices (monetary accommodation), triggering the first full blown currency crisis and social unrest in the following year as corrective actions were implemented.
While it is possible to run deflationary policy (currency board have neutral policy), reserve collecting central banks tends to extend credit cycles if they run inflationary policy to overcome a US slowdown from a tightening cycle, leading to Argentina style outcomes.
The Federal Reserve and ECB up to 2022 triggered inflation levels not seen since Great Inflation by operating an ample reserves regime (single policy rate) claiming inflation was transient from supply chain bottleneck in a re-emergence of spurious supply side doctrine.
The US government and the International Monetary Fund also blamed Putin in another supply side twist. Putin’s war is still on however.
(Colombo/July27/2025)
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