ECONOMYNEXT – Sri Lanka Central Bank stubbornly defended the 5% inflation target it recommended and signed with the government for the next three years citing that it was the only “optimal solution” and rubbished claims that the target is high and erodes the purchasing power of the general public.
Economists and monetary policy critics have strongly advocated that the Central Bank lower its official inflation target from 5% to 2%, emphasizing that a lower target is essential to break the country’s historical cycle of currency instability.
Proponents of the 2% target argue that a 5% baseline implicitly embeds a continuous, compounding erosion of domestic purchasing power, increasing price levels by over 15% across a three-year window.
In a country recovering from hyperinflation, critics contend that a targeted 5% annual inflation creates an environment where nominal prices and living costs permanently outpace real wage growth, continually straining lower- and middle-income households.
However, the Central Bank recommended to the government and signed a three-year agreement to maintain the 5% inflation target for the three years through October 2029.
Central Bank Governor Nandalal Weerasinghe explained at a panel discussion with his junior officers that countries choose inflation targets depending on their growth potential and ability to grow.
“So, this is where one can argue, why 2% inflation, is it better? Looking at the purchase power, it looks better, but it’s not better,” he told the gathering in response to a question.
“It is worse, because it will create a country that can grow, much lower below its potential…. It’s not welfare optimization. It will make a lot of people worse off than it will make a lot of people better off.”
A primary structural argument for adopting a 2% inflation target centers on external stability and protecting the Sri Lankan rupee.
When Sri Lanka maintains a 5% inflation target while its key international trading partners such as the United States, Eurozone, and major Asian economies aim for 2%, a structural inflation differential of around 3% is built directly into the economy.
According to economic theory and historical precedent, this persistent inflation gap exerts steady downward pressure on the domestic currency, forcing nominal exchange rate depreciation.
Advocates argue that lowering the target to 2% would align Sri Lanka with global standards, anchor long-term exchange rate expectations, and prevent recurring balance-of-payments vulnerabilities.
Only 5%
However, Weerasinghe said the 5% target has the “right balance” and the Central Bank had conducted extensive research before arriving at the decision.
“I think, we don’t see any other counterfactual to say, it’s not 5%, it’s 4%, or 2%, or 3%, or 6%, or 7%,” he said.
“A lower inflation target can make the solution worse than what we think…. It won’t be better because everyone can be benefited out of higher growth.”
“If you are coming to a solution, where inflation can drag down the growth below potential, that won’t be the optimal solution.”
“We are all convinced and that’s why we have made the recommendation, government also agreed.”
He said the central bank will reassess and come up with the right level that could be lower in the future and that decision will be data-driven and evidence-based.
Analysts have stressed that a 2% inflation target is critical for lowering long-term interest rates and encouraging capital investment.
Under a 5% target, which carries an allowed accountability band of 2 percentage points, permitting inflation to fluctuate between 3% and 7%, lenders and foreign bondholders demand a higher inflation risk premium to compensate for potential price volatility.
This inflates domestic borrowing costs for both private enterprises and the government. By committing to a tighter 2% anchor, the central bank would provide greater policy credibility, reduce nominal interest rates across the yield curve, and foster a far more predictable environment for long-term private sector investment and debt sustainability.
The data showed, the Central Bank missed the inflation targets for most quarters in the three-year period through end September 2026.
The Bank has blamed lower energy prices for disinflation and missing the target below the lower band of 3% and higher energy prices for breaching the target above upper limit of 7%. (Colombo/October 09/2026)