Inflation – Public Enemy Number One

(An article based on the Keynote Address delivered by Dr. P. Nandalal Weerasinghe, Governor of the Central Bank of Sri Lanka, recently at the Annual Research Symposium 2023 of the University of Colombo. Part I of this article appeared yesterday.)

Sri Lanka’s disinflation process

The outcomes of the policy efforts discussed above have eventuated since late 2022. Sri Lanka’s inflation started moderating from its peak levels of around 70 per cent (year-on-year) in September 2022, marking the beginning of the country’s disinflation process. Accordingly, Colombo Consumer Price Index (CCPI, 2013=100) based headline inflation moderated to 57.2 per cent (year-on-year) by December 2022, and further decelerated in the nine months ending September 2023. The pace of deceleration in headline inflation was slower in Q1-2023 due to the impact of the electricity tariff revision. However, headline inflation decelerated sharply in Q2-2023, reaching single-digit levels in June 2023. The moderation in inflation continued thereafter as well, where CCPI based headline inflation eased to a low level of 1.3 per cent (year-on-year) by September 2023.

In terms of economic factors, this process was supported by subdued aggregate demand conditions due to tight monetary and fiscal policies, improvements in domestic supply conditions, improved external sector performance, some normalisation of global commodity prices, and the passthrough of such reductions to domestic prices. Statistically, the disinflation process was influenced by both the momentum effect and the base effect, with a higher contribution from the latter.

Over the medium term, following the rapid disinflation thus far in 2023, inflation is expected to stabilise at the targeted level of 5 per cent, supported by appropriate monetary policy measures, along with improving supply conditions. Moreover, Sri Lanka’s disinflation process is expected to turn around from September 2023, with the dissipating impact of the favourable base, thereby facilitating the convergence of inflation towards the targeted level. Although some upward movement in headline inflation is likely in the near term driven by the planned upward adjustments to administratively determined prices and tariffs, the impact of such measures is expected to be short-lived. Further, the ongoing geopolitical tensions in the Middle East and possible tax measures by the Government remain the major upside risks to inflation in the near term.

The new Central Bank legislation

The legislative framework introduced by the Central Bank of Sri Lanka Act, No. 16 of 2023 (CBA) would reinforce price stability in the period ahead, while ensuring that inflation expectations remain well anchored. The new Central Bank Act gives prominence to price stability by stating that the primary objective of the Central Bank shall be to achieve and maintain domestic price stability. In pursuing this primary objective, the Central Bank shall take into account, inter alia, the stabilisation of output towards its potential level. The other object of the Central Bank shall be to secure the financial system stability.

Under the CBA, there shall be a Monetary Policy Board of the Central Bank, which is charged with the formulation of monetary policy and implementation of a flexible exchange rate regime, in line with the flexible inflation targeting framework, in order to achieve and maintain domestic price stability. The creation of a separate decision-making body in addition to the Governing Board, signifies the importance placed on independent monetary policymaking for achieving domestic price stability by the new legislation.

Also, the CBA formally recognises flexible inflation targeting as the monetary policy framework and requires the signing of a monetary policy framework agreement setting out the inflation target to be achieved by the Central Bank. Accordingly, the Central Bank entered into an agreement with the Minister of Finance in October 2023, where it was stated that the Central Bank shall aim to maintain quarterly headline inflation rate at a target of 5 per cent with a margin of ±2 percentage points.

If the Central Bank fails to meet the inflation target by the margin determined in the Agreement for two consecutive quarters, the Monetary Policy Board shall submit a report to the Parliament through the Minister, which shall also be made available to the public, setting out the reasons for the failure to achieve the inflation target; the remedial actions proposed to be taken by the Central Bank; and an estimate of the time period within which the inflation target shall be achieved. These provisions, along with enhanced transparency and accountability, would ensure that inflation in Sri Lanka would be maintained at low and stable levels in the period ahead, thereby benefitting all stakeholders in the economy.

Concluding remarks

Headwinds due to consecutive economic shocks in recent years have severely affected Sri Lanka’s economic activity in 2022 and early 2023, inflicting hardships on individuals and businesses. The Government and the Central Bank implemented painful but unavoidable policy measures aimed at restoring macroeconomic stability. The near-term economic stabilisation measures implemented thus far are unprecedented and started delivering the expected positive outcomes. Inflation declined sharply to a little over 1 per cent (year-on-year) by September 2023 and is expected to hover around the targeted level over the medium term. External sector performance improved and the exchange rate appreciated in 2023. The IMF programme is progressing and the stability of the financial sector has been preserved amidst numerous challenges.

Monetary policy will remain focused on ensuring price stability over the medium term, while giving due regard to stabilising economic growth towards its potential, under a flexible inflation targeting policy framework. Going forward, the conduct of monetary policy will continue to be based on a forward-looking and data-driven approach, supported by recent and expected macroeconomic developments and projections, both domestic and global. Timely adjustments to policies and strategies of the Central Bank will be made under the flexible inflation targeting framework, as and when new information becomes available. Maintenance of inflation at a low and stable level would eliminate large swings in interest rates, thus creating an enabling environment for businesses.

The Central Bank of Sri Lanka Act would allow more independence to the Central Bank, limiting monetary financing, and thereby strengthening policies targeted at managing inflation and inflation expectations. With the primary object of the Central Bank being the maintenance of domestic price stability, the new Act will serve as a key buffer for the Sri Lankan economy against inflation. Moreover, the Central Bank remains committed to maintaining headline inflation at the targeted levels, thereby tackling inflation – public enemy number one transparently and proactively.

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