ECONOMYNEXT – Sri Lanka’s “accommodative” monetary policy stance including a rate cut in November 2024, would push up cost of living to the 5 percent target by the third quarter of 2025, the central bank has said.
Overly accommodative policy could trigger external risks, the agency said in an inflation report submitted to the Finance Minister after better than targeted inflation.
Sri Lanka’s central bank missed the lower threshold in its 5 percent plus or minus 2 percent inflation target in the second and third quarters of 2024.
In November the central bank cut its policy rate to 8.0 percent with 50 basis points either way for standing facilities.
“…[T]he recent further loosening of monetary policy in November 2024, would be appropriate to bring inflation towards the target of 5 per cent by around the third quarter of 2025,” the inflation report said.
“It is also important to note that given the exceptionally high inflation levels Sri Lanka experienced in 2022 and 2023, a brief period of lower-than-targeted inflation could provide some relief to households and businesses that are still recovering from the large increase in the cost of living and cost of production, respectively.”
Sri Lanka’s reserve collecting central bank (de facto inconsistently pegged) frequently goes to the International Monetary Fund frequently after printing money to push down rates, which are incompatible with maintaining external stability.
Currency crises have come in quick succession after the end of a 30-year civil war as rates were cut with inflationary direct or open market operations to target mid -single digits inflation even without a formal inflation target.
All errors in interest rate targeting are compensated with currency depreciation (exchange rate as the first line of defence) and rates have been corrected as the last line of defence amid import controls, analysts say.
In 2022 Sri Lanka defaulted after two and half years of extremely accommodative monetary policy.
Deflationary policy created balance of payments surpluses from around September 2022 and brought headline inflation to an abrupt halt amid a credit contraction.
However private credit has picked up.
“While the external sector has stabilised to a great extent, the higher-than-expected economic growth observed thus far in 2024 and the robust growth anticipated during the period ahead suggest a possible rise in aggregate demand going forward,” the central bank said.
“In addition, the planned relaxation of motor vehicle imports after several years could also result in higher import demand and a deficit in the external current account is expected from 2025.
“In such a context, an overly accommodative monetary policy stance could exacerbate import demand at times of resumption of external debt servicing, thus posing risks to external sector stability and inducing a large depreciation of the exchange rate.
“Therefore, close policy coordination between the Ministry of Finance and the Central Bank would be necessary to maintain the stability of the external sector, especially in an uncertain global environment.”
Sri Lanka banned vehicle imports, stopping credit for vehicles as money was printed for growth in 2020. In February vehicle imports are to be allowed, after 5 years.
Analysts have pointed out that vehicle imports cannot create balance of payments troubles as in the absence of inflationary open market operations, other credit has to be crowded out to finance car imports.
Related Sri Lanka vehicle imports not a threat to rupee but inflationary open market operations will be
However, if there are inflationary open market operations to target a single policy rate there will be excessive imports and the currency will depreciate under the flexible exchange rate.
A bank of issue, creates an imbalance between savings and investments through its domestic operations.
Inflationary open market operations in a reserve collecting central bank (de facto managed exchange rate) trigger an external deficit by making banks lend more than they get as deposits and loan repayments.
Deflationary operations result in a balance of payments surplus. (Colombo/Jan24/2025)
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