The Banker
Sri Lanka’s inflation trajectory is becoming increasingly uncomfortable. The Central Bank of Sri Lanka (CBSL) has a formal inflation target of 5%, but headline inflation has moved sharply away from that level in recent months — from just 2.2% in March to 5.4% in April, 5.5% in May, 6.8% in June, 7.3% in July and 8.0% in August.
The question now is not simply what caused the increase. It is whether monetary and fiscal policy are moving quickly and coherently enough to prevent a temporary inflation shock from becoming a more persistent problem.
There is an important distinction here. CBSL’s formal target is a quarterly average headline inflation rate of 5%. A formal failure occurs only when inflation deviates by more than two percentage points from the target — meaning above 7% or below 3% — for two consecutive quarters.
On that measure, it would be premature to say that CBSL has already formally breached its target twice. First-quarter inflation averaged about 2%, while second-quarter inflation averaged about 5.9%. The third quarter has so far produced readings of 7.3% in July and 8.0% in August, but September’s figure is still required to calculate the full quarterly average.Nevertheless, the direction is unmistakable. Inflation has accelerated rapidly.
COL Crisis
The May decision to raise the Overnight Policy Rate by 100 basis points to 8.75% deserves scrutiny in that context. CBSL acted after April inflation reached 5.4%, citing higher energy prices but also stronger domestic demand, continued credit expansion, credit-driven imports and other pressures. The Bank itself warned that inflation was likely to remain above the 5% target for some time.The question is whether that response was sufficiently timely and sufficiently strong.That is a legitimate policy debate. But it should be based on evidence rather than political speculation. The IMF, following its June mission, described the 100-basis-point rate increase as part of CBSL’s response to the inflation shock and noted the impact of the Middle East conflict on Sri Lanka’s economy.What should concern policymakers now is that the inflation problem has continued to broaden. August inflation reached 8%, with food inflation at 8.5%, while non-food inflation remained high at 7.7%. CBSL attributed much of the August increase to food prices and a statistical base effect, but the non-food number demonstrates that the problem cannot simply be dismissed as a food-price shock.
This brings us to fiscal policy.
Sri Lanka cannot afford a situation in which monetary policy is attempting to contain inflation while fiscal policy simultaneously stimulates domestic demand. The Treasury and CBSL do not have to agree on every instrument, but they must operate within a coherent macroeconomic framework.The Government also needs to resist the temptation to treat fiscal expansion as the easiest answer whenever growth slows. Sri Lanka has already paid an enormous price for fiscal indiscipline, excessive borrowing and weak policy coordination. Debt sustainability, fiscal credibility and price stability must remain central to the post-crisis recovery.
Discipline
The IMF has repeatedly emphasised the importance of disciplined monetary and fiscal policies. Its recent assessment noted that CBSL had refrained from monetary financing of the budget deficit and that monetary and exchange-rate policies remained focused on stability and inflation control.That institutional discipline must now be protected.The Government should not second-guess the Central Bank’s operational independence. Equally, the Central Bank cannot operate in a policy vacuum. The Treasury and CBSL need a much stronger and more transparent dialogue on inflation forecasts, fiscal assumptions, credit growth, imports, energy pricing and the risks to inflation expectations.There is also a communication issue. When inflation moves from 2.2% in March to 8% in August, the public deserves a clear explanation of what changed, why earlier projections proved inadequate and what policy response is now being considered.Sri Lanka has come too far since the 2022 crisis to allow complacency to return.The issue is therefore bigger than one interest-rate decision or one month’s inflation number. It is about policy credibility.The 5% target remains important even if the formal breach mechanism has not yet been triggered. Repeatedly moving away from the target can weaken confidence if the public begins to believe that targets are merely aspirational.
Conclusion
The lesson from the crisis should be clear: monetary policy must remain credible, fiscal policy must remain disciplined, and the two must work together.Sri Lanka cannot afford to discover, yet again, that policy responses came only after the problem had become much larger. All those price sector executives who jump from one party to another better step in and advice the government to bring down the COL .