Inflation and benchmark Treasury bill rates moved upwards last week and dealers said inflation could pick up as global food prices increase but were confident the Central Bank would keep policy rates unchanged so as to fill the growth gap, hopeful the government would not expand its expenditure beyond the IMF mandate adding further inflationary pressure.

The government statistics office announced last week that headline inflation had increased to 6.5 percent in January 2010, from 4.8 percent in December 2009 as food prices increased by more than four percent year-on-year.

Meanwhile, benchmark Treasury bill rates continued to inch upwards at last week’s primary auction. Since last November these rates kept picking up marginally each week.

The three-month Treasury bill rate increased marginally to 7.95 percent last week from 7.86 percent a week earlier. The rate of the six-month bill moved up to 8.90 percent from 8.86 percent while the one-year bill saw its rate pickup marginally to 9.46 from 9.41 percent.

The three-month, six-month and one-year Treasury bill rates were 7.25 percent, 8.33 percent and 9.17 percent respectively as at end November 2009.

"We expected inflation to pick up because global commodities and food prices are on the rise. India is already hit by food inflation, prices increasing by a much as 14 percent, and its reserve bank has increased policy rates in a bid to curtail inflation generated by credit growth.

"Sri Lanka is already experiencing the results of high global food prices and that is why inflation has picked up. We expect headline inflation to reach close to 10 percent by October or November. This could be higher unless domestic agriculture volumes pick up and government stays within fiscal targets as set out with its agreement with the IMF," a dealer said.

Sri Lanka entered 2010, a year of presidential and general elections, with a fiscal position the Central Bank termed ‘precarious’ warning against reckless spending and public sector wage increases during the year as this could lead to inflation and curtailment of private sector credit.

"We feel the Central Bank would keep policy rates as they are because government policy at the moment is to cover the growth gaps in the economy by encouraging private sector credit growth.

"The election cycle is bound to inflate government spending but once the general election is held the fiscal position should consolidate and the government would have to contain its budget to 6.5 percent in 2010 according to the agreement with the IMF. If this is the case, then inflation would be still manageable and there would not be pressure on interest rates," another dealer said.

"For the moment, we believe the Central Bank’s forecast would hold and inflation would not exceed beyond single digit figures," a dealer said.

Because of high global food and commodity prices 2008 was a bad year with inflation peaking at 28.2 percent in July that year but it gradually declined to 0.7 percent in September 2009 only to pick up again to the current level of 6.5 percent.

As inflation began to ease, the Central Bank eased its tight monetary policy stance in a bid to encourage private sector credit growth, but commercial banks were too slow to respond prompting a presidential directive to slash lending rates to a maximum of 12 percent to selected sectors like agriculture, tourism and SMEs.

As market interest rates began to adjust downwards, credit to the private sector began to improve as well.

Credit to the private sector continued to grow month-on-month since September 2009, reaching above one percent last November. As at November 2009, credit to the private sector was Rs. 1.188 trillion, up from Rs. 1.176 trillion during the month before, a positive but marginal 1.02 percent growth, Central Bank data showed.

However, year-on-year, private sector credit growth was still a negative 5.8 percent for November 2009 with growth for November 2008 a positive 7.6 percent.

After recording negative growth each month since May 2009, credit to the private sector gained a marginal 0.35 percent from Rs. 1.17 trillion in August to Rs. 1.18 trillion in September, but this was still in the negative range after recording 5.2 percent growth in September 2008.

The Central Bank earlier this month said private sector credit growth would be in the range of a positive 13 percent.

"Given policy directions of the government a tightening of policy rates is likely to send the wrong signal to the market," a dealer said.

Dealers said the Central Bank could use other instruments to control inflationary pressure, such as imposing a penal rate on commercial bank borrowings from the Central Bank.