Sri Lanka for Inflation Targeting from 2012 as Priority Shifts to Maintaining Prices over Growth

04th January 2012, www.lankabusinessonline.com

Sri Lanka is moving to a more explicit inflation targeting environment setting a level of 5 to 6 percent for 2012 and priority has been shifted to maintaining prices over growth, Central Bank Governor Nivard Cabraal said.

Sri Lanka is expecting 8.0 percent gross domestic product (GDP) growth in 2012 on the back of 8.3 percent growth in 2011 boosted by a lower budget deficit and the end of a war two years earlier.

"On our path the central bank will be keen to accommodate the higher growth but our priority will certainly be inflation," Governor Cabraal said.

"So based on that factor we will want to deliver single digit inflation between 5.0 and 6.0 percent in 2012."

Sri Lanka's budget deficit is expected to fall to 6.2 percent of GDP in 2012 for the third successive year and the authorities have revised an inflation index, Cabraal said.

Ten years ago when the Central Bank was first contemplating moving to an active inflation targeting framework, a commitment to lower inflation was also identified as a requirement, he said.

"Over the last five years we actively worked on those measures," Cabraal said. "We have been able to deliver price stability over the past three years.

"That now gives us the confidence to say that move to a new level, that we can use these new strengths and therefore from the year 2012 onwards we will with greater confidence target inflation as well."

So called fully fledged inflation targeting involves the commitment to target one anchor - an inflation index - and allowing the exchange rate to float.

As Sri Lanka has a dollar soft peg, the Central Bank will still be juggling with two anchors, a 'domestic anchor' in terms of the inflation index and an 'external anchor' in terms of the exchange rate.

"We will be looking at the exchange rate as a key stabilization factor," Cabraal said.

Such dual anchor monetary regimes are prone to balance of payments crises, but countries have been able to keep inflation down by consistently having interest rates higher than the anchor US currency and having a more interventionist exchange rate policy.

The International Monetary Fund has named such regimes inflation targeting lite (IT lite).

If the inflation is low enough such regimes can keep the exchange rate peg, as countries like China has proved as pressure on the exchange rate is also a signal to raise rates.

For inflation targeting to succeed the Central Bank has to prioritize it as an objective so that it is ready to raise interest rates whenever necessary, without regard to other factors such as 'growth'.

Sri Lanka is currently seeing balance of payments pressure which some analysts attribute to a delay in tightening policy in the early part of 2011, when credit growth and inflation picked up.

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