ECONOMYNEXT – Sri Lanka’s current low inflation is due to transitory ‘supply side’ factors and will go up to 5 percent by the third quarter of 2025, the central bank said in a report, after achieving Singapore style for two quarters and missing it high inflation target of up to 7 percent.
Inflation was 1.4 percent in the second quarter and 0.8 percent in the third quarter below the 3 percent lower threshold of its 5 percent, plus or minus 2 percent inflation target.
“The deviation of headline inflation from the target in the second and third quarters of 2024 can be largely attributable to transitory supply-side factors, particularly significant reductions in energy prices,” the central bank said in a report submitted to parliament through the Finance Minister.
“The current forecasts suggest that headline inflation will remain low in the coming months as well.”
By the third quarter of 2025, headline inflation would reach levels within the band “with the dissipation of the effects of the supply-side factors along with steady demand-side factors in the period ahead,” the report said.
“Low levels of inflation in both the second and third quarters of 2024 were mainly driven by a sizeable, more-than-anticipated, reduction in energy and transport-related inflation, which is primarily regarded as supply-driven,” the central bank claimed.
“Significantly higher than anticipated” price cuts in electricity, fuel and LP gas, reduced inflation from the projections made the central bank earlier.
The central bank however said currency appreciation helped “ease inflationary pressures”.
The Sri Lanka rupee had appreciated by 8.2 per cent against the US dollar during the nine months ending in September 2024.
“This appreciation had a favourable impact on inflation by reducing import prices and triggering second-round effects associated with lower imported inflation,” the report said.
“While this was partly reflected in the downward revisions of energy prices mentioned above, the appreciation of the rupee is expected to have also contributed to subdued prices in non-energy items within the consumer price index.”
Currency appreciation is allowed (the decision on what rate to buy dollars to stop appreciation and create new rupee liquidity) based on the central bank’s exchange rate policy.
Sri Lanka is supposed to have an ‘flexible’ exchange rate, which is a type of inconsistent managed exchange rate which is neither a clean float nor a hard peg.
Sustained upward pressure is only possible if there is deflationary policy, and the newly created rupees are mopped up to stop them being loaned by banks for investment and imports.
Under International Monetary Fund programs exchange rates are usually not allowed to appreciate despite deflationary policy in the first year or two amid a credit contraction, on Mercantilist ‘competitive exchange rate’ considerations.
Under an IMF program, an age-of-inflation central bank that gets into external trouble due to anchor conflicts or a high inflation target is also juggling several de facto anchors, analysts say.
A downward ceiling on domestic assets, commits it to deflationary policy, external and domestic stability and allows it to collect foreign reserves (a complementary target) under a so-called ‘reserve adequacy matrix’.
However, a high inflation target (a monetary policy consultation clause) can force a bank of issue to print money through open market operations, adding extra rupee reserves into the banking system maintain policy interest rate incompatible with external stability, analyst say.
Sri Lanka’s economy has recovered strongly amid below target inflation, which is in line with levels achieved in countries like Singapore.
Concerns have been raised at high excess liquidity injected in October. Inflation would get back to targeted levels by the third quarter of 2025, the report said. (Colombo/Jan25/2025)
