ECONOMYNEXT – Sri Lanka’s central bank has revealed that its demand for a 5 percent rise in cost of living a year was based on arguments including targets in the third world, econometrics involving its own past performance and a belief that inflation was needed for growth.
“Look at it this way, we are coming down from 70 percent inflation,” Assistant Governor C Amarasekara told reporters, answering a question whether, central bank could relent a little and give the people a lower level of inflation.
“And even the IMF was not sure whether we would be able to bring down inflation to below 10 percent within the time that Sri Lanka saw.
“So, I do not think it is the time to talk about a lower target now.”
It was pointed out that the 5 percent inflation target was not a new one and the agency had insisted on ‘mid-single-digits inflation’ even in the past.
IMF programs seem to expect monetary instability in the form of chronic depreciation to its programs especially after 1978.
Meanwhile Amrasekera said one of the statistical effects of recent deflation would be that 12-month inflation would spike over the next year, he said.
The central bank won a 5 percent inflation target from Sri Lanka’s President Ranil Wickremesinghe and has undershot the target, providing a strong platform of stability for the country to recover.
There has been praise for central bank’s recent deflationary policy, though the agency had come under fire for liquidity injections in the last quarter.
Non-Monetary Inflation
Meanwhile the central bank also blamed ‘supply shocks’ for demanding a high inflation target, saying inflation was volatile, and not its own operating framework with bad anchor and anchor conflicts for volatile and high inflation.
“In countries like ours, we face supply shocks always, very large supply shocks, even at times, even larger than what we can tolerate,” Amarasekera said outlining the central bank’s thinking.
“So, whenever there are large supply shocks, that tends to move inflation up and down a lot. That’s why in countries like ours, inflation is volatile.
“So, when inflation is volatile, it’s very difficult for a country like ours, we are a small economy. So a lower inflation target, although desirable, will not be achievable.
“So, only if we strengthen our economy to an extent that most of the supply side shocks can be sort of mitigated, then I think that is the time for us to move to a lower inflation target.”
However, critics have said it was un-anchored money or anchor conflicts that made Sri Lanka’s inflation diverge from developed nations, especially after the IMF second amendment in 1978.
The developed country level inflation experienced before 1978, despite an overwhelming portion of the Colombo Consumer Price Index, being made up of foods.
Inflation for Growth
The central bank also believes that lower inflation will kill growth.
“Our underlying inflation pressure is around 4 percent,” Director of Economic Research, Sujeetha Jegajeevan said.
“So when we see that the possible demand side inflation is around 4 percent, if you are thinking of targeting at 2 percent, what we have to do is we have to tighten policies too much. And that is going to kill economic growth. And that is not going to benefit anyone.”
Some observers have been seeking a lower inflation target in part to block the central bank from running discretionary inflationary policy under cover of a 5 percent inflation target, triggering external crises, which then kills growth in a stabilization crisis.
Each stabilization crisis after chasing a 5 percent inflation target with open or direct market operations costs about a year or two of growth and economic contractions.
The stabilization crisis, as well as higher energy and food prices that come from the initial collapse of the currency tends to generate social unrest, ouster of elected governments and out-migration to countries with better central banks or monetary authorities.
After each currency crisis inflation spiked beyond the 5 percent target.
In general, the currency crises tend to come in Sri Lanka (and elsewhere) when the US tightens and reserve-colleging central banks go out of step and run an extended credit cycle, analysts have said.
Past Performance
The central bank demanded the 5 percent inflation target after statistical studies, Jegajeevan said.
“Before fixing this 5 percent, there was technical work that went in and we had research and we applied several methods.”
The central bank had looked at historical inflation, from 2009 to 2021, the average was 5.1 percent with a standard deviation of 2.1 percent. The majority of the time inflation was between 3 and 7 percent, an official said.
The central bank “noticed from several econometrics, several research method,…that close to around 5 percent would be best to manage the growth expectations as well” he said.
Inflation targets of “peer countries” and “developing countries” have lower or higher targets, but apart from developed countries, it is very rare for developing countries to have 2 percent targets, but some have 4 to 5 percent.
It is not clear whether countries with lower inflation targets and have therefore greater monetary stability and infrequent crises, do not stay poor for long.
Analysts had also pointed out that reserve collecting central banks that try to target inflation without a clean float also runs into anchor conflicts, and instability.
“As I said before, this is open for discussion,” Amarasinghe said. “We will continue the dialogue and when time comes, this is something we could consider. But as I said, this is not the time.”
The central bank should tighten policy now if there was a 2 percent target, another official said.
“If I put this into the current context, if we had a 2 percent target, we should have already started the tightening cycle, because we project Q3, Q4 this year, later around 5 and maybe 6 percent inflation,” Kasun Pathirage from the agency’s Economic Research Department said.
“So, we might have already started a tightening cycle if we had a 2 percent inflation target or low inflation target.” (Colombo/Feb16/2025)