Sri Lanka’s central bank has promised single digit inflation amid deflationary external conditions and the possibility of a looser stance and lower interest rates in 2009, in its annual road map for monetary policy.

In the last few months inflation has been falling with the effects of external deflationary conditions flowing into the country through a soft-dollar peg.

Measured by the Colombo Consumer Price Index (CCPO) consumer prices fell to 14.4 percent in December from a peak of 28.2 percent in June.

"We expect this declining trend in inflation to continue in the period ahead, and for the inflation rate to reach a single digit level by mid 2009," Central Bank governor Nivard Cabraal said, unveiling the monetary policy road map for 2009.

"Accordingly, inflation would reach around 8.0 – 9.0 per cent by mid 2009 and will continue the moderated trend."

Inflation Target

The central bank is projecting base-case inflation of around 9.0 percent in 2009, best case inflation of around 5.0 percent and a worse case scenario of around 12 percent. In 2008 the central bank predicted inflation of around 10 to 11 percent, revised it up to 20.0 percent in the third quarter and ended up with 14.4 percent as the global commodity bubble fired by the US Federal Reserve collapsed ignominiously.

Unusually the central bank also expressed an inflation target of 10.0 percent by the gross domestic product deflator.

The GDP deflator is however a complex and unsuitable figure to target as it has lagged effects, and is even less transparent than a consumer price index, especially in the context of growing distrust about the integrity of national statistics in the country.

In a year that inflation falls, the GDP deflator can be high, as opposed to a low figure when inflation is climbing over one year to the next.

In the third quarter of 2008 for example, the GDP deflator was 18.5 percent.

But in general Sri Lanka’s monetary policy was kept tight by Cabraal in 2008, despite several limitations and pressures.

The island does not operate a policy rate environment. It engages in quantity targeting of the monetary base (reserve money) with two discount windows at 12.0 percent and 19.0 percent and dollar peg.

In 2008 Sri Lanka expected the monetary base to grow about 15 percent which was revised down twice during the year to counter rising inflation.

Unstable Peg

The country finally ended the year with reserve money growth of just 2.3 percent after statutory reserve ratio cuts amid a currency crisis in the third quarter, which sucked up liquidity from the system due to dollar peg defence.

The peg is made unstable not only by the discount windows but more so by a capacity to sterilize outflows (balance of payments deficits) to maintain reserve money and also finance the government through printed money overdrafts and securities purchases.

The sterilization of outflows from September 2008 stampeded the country into a currency crisis and the central bank abandoned its peg defence only after losing about a third of its reserves. In Sri Lanka reserves can be also lost by meeting state foreign obligations.