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ECONOMYNEXT – Central Bank of Sri Lanka’s reluctant decision to hike rates at time when the it is running clearly deflationary policy with an ad hoc peg, has drawn praise from the International Monetary Fund.

Sri Lanka’s central bank said a 100 basis point rise in the policy rate was made as the last prior action of an IMF deal amid “some differences between the CBSL and IMF staff on the inflation outlook”.

“CBSL’s decision to raise the policy rate is appropriate and in line with its objectives set under the inflation targeting framework,” Peter Breuer, Senior Mission Chief for Sri Lanka, and Masahiro Nozaki, Mission Chief for Sri Lanka said in a statement.

“It reflects CBSL’s commitment to the inflation target and is an important part of the disinflation strategy in the EFF program, which is fully committed by the Sri Lankan authorities and supported by the IMF.”

Central Bank of Sri Lanka’s reluctant decision to hike rates at time when the agency is running clearly deflationary policy with an ad hoc peg, has drawn praised from the International Monetary Fund.

Analysts however have pointed out that Sri Lanka does not operate an inflation targeting framework as it does not have a clean float, which is why the country had serial currency crises in 2015/16, 2018 and 2020-22 and eventually defaulted on external debt.

Of late the central bank has been running clearly deflationary policy, reporting a balance of payments surplus, which is also possible only if there is a pegged exchange rate.

A floating exchange rate central bank with an inflation target to determine the expansion of reserve money cannot change its net international reserves.

Central Bank Governor Nandalal Weerasinghe said the agency brought 308 million US dollars from the market this week after a surrender rule was reduced amid deflationary policy and the rupee started to appreciate. The surrender rule will be removed from next week.

Sri Lanka’s 12-month inflation hit around 70 percent in 2022, as a flexible exchange rate pushed down by a surrender rule collapsed from 200 to 370 to the US dollar. Twelve month inflation has since eased to 50 around percent.

“Sri Lanka’s inflation is declining but remains at a very high level, which has been disproportionally hurting the poor,” the IMF statement said.

“Upside inflation risks could reverse the trend and lead to persistently high inflation which is extremely costly to the economy.

“Therefore, CBSL’s decision to raise the policy rate shows its commitment to reduce inflation more quickly and firmly towards the single-digit target.

“Durable disinflation would help boost market confidence, reduce excessive risk premia and ease the financing conditions for the corporates, especially the small and medium enterprises, which supports recovery.”

Changes in consumer price indices are a lagged effect (usually about 1.5 years) of inflationary policy of a central bank.

But effects of inflationary policy in a pegged exchange rate bank is seen with a lag as short as four to six weeks through forex shortages, according to analysts. That is why hard pegs without policy rates have neither high inflation nor high interest rates.

In Sri Lanka, traded goods have generally stopped rising partly helped by tighter US policy, as central bank Governor Nandalal Weerasinghe imposed a guidance peg putting in place a partially credible anchor for monetary policy with two-way interventions in mid 2022.

Purchases of dollars have exceeded sales for around four months and banks have also settled pent up foreign payments.

The food index in Sri Lanka’s of a revised Colombo Consumer Price Index, which peaked at 246.9 points in September 2022, shortly after the central bank stopped sterilizing interventions made with Indian ACU money fell absolutely to 234.7 points in February.

With negative private credit (de-leveraging) the central bank no longer has the ability drive inflation up through the policy rate as market rates are also twice that.

One remaining tool the central bank has to generate inflation is through depreciation of the currency.
But liquidity created from dollar purchases – to stop the appreciation of Sri Lanka’s now ad hoc exchange rate peg – are absorbed in overnight liquidity shortages in the banking system.

Large injections through open market operations or through encouraging the use of privately sterilized money parked in the central bank can also created demand, but that can be done at any rate.

Market interest rates which determine what happens in the real economy, are around 29 percent compared to the policy rate of 16.5 percent. (Colombo/Mar04/2023)

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