About Monetary Policy
Overview
Monetary policy is the process by which a Central Bank manages the supply and the cost of money in an economy mainly with a view to achieving the macroeconomic objective of price stability.
Central Bank of Sri Lanka is responsible for conducting monetary policy in Sri Lanka, which mainly involves setting the policy interest rates and managing the liquidity in the economy. The monetary operations of the Central Bank influence interest rates in the economy, affecting the behavior of borrowers and lenders, economic activity and ultimately the rate of inflation. Therefore, the Central Bank uses monetary policy to control inflation and keep it within a desired path.
Price Stability
Price stability is a situation where there are no wide fluctuations in the general price level in the economy, which helps to achieve sustainable economic growth. When the prices fluctuate at a low rate, they would not have any significant influence on the economic decisions of agents of the economy, viz. households and firms. Moreover, price stability helps better anchor inflation expectations among the public, which in turn makes it easier to keep actual inflation at low and stable levels. Therefore, stable prices would not distort the economic decisions regarding what to produce and how to produce, thus enabling efficient allocation of resources in the economy leading to economic stability and sustainable growth in the economy over the longer term. Accordingly, as per CBA, the Central Bank, in pursuing its primary objective of achieving and maintaining domestic price stability, shall also take into account, inter alia, the stabilisation of output towards its potential level.
Monetary Policy Framework
The Central Bank conducts monetary policy in line with a flexible inflation targeting (FIT) framework, aimed at maintaining headline inflation at the target rate of 5 per cent level over the medium term while supporting economic growth to reach its potential. In terms of operational aspects of this framework, the Central Bank uses its policy instruments to guide short term interest rates, particularly the average weighted call money rate (AWCMR) as the operating target.
Previously, the Central Bank conducted monetary policy within an enhanced monetary policy framework with features of both monetary targeting and flexible inflation targeting (FIT). Under this enhanced monetary policy framework, the Central Bank attempted to stabilise inflation at mid single digit levels, while supporting the growth momentum of the economy and flexibility in exchange rate management. Similar to the current practice, the AWCMR was used as the operating target.
During the early 1980s, the Central Bank adopted monetary targeting as its monetary policy framework, and monetary aggregates were the key nominal anchors in the conduct of monetary policy. Under a monetary targeting framework, the changes in money supply are considered the primary causal factors affecting price stability. However, given the rising volatility in the money multiplier and velocity amid a weakening relationship between money supply and inflation, the role of monetary targets as a nominal anchor became uncertain and also complicated the Central Bank’s communication strategy, causing the Central Bank to upgrade its monetary policy framework.
The Central Bank conducts its Open Market Operations (OMO) within the corridor of interest rates formed by its policy interest rates, i.e. the Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate (SLFR), to achieve the intended inflation path. Policy interest rates are periodically reviewed and adjusted appropriately, if necessary, to guide the interest rate structure of the economy with a view to achieving the desired path of inflation.