Central Bank mulls inflation target

At a time when global policymakers are rethinking the merits of targeting inflation, Sri Lanka’s central bank could buck the trend by launching such a policy framework as soon as next year, its Governor said Tuesday.

Since the financial crisis and the economic downturn, inflation-targeting policies have increasingly come under the spotlight, with critics saying that their narrow focus blinkered central bankers amid the pre-crisis boom in asset prices.

In an interview with Dow Jones Newswires during a trip to London, Governor Ajith Nivard Cabraal indicated that he is mindful of the possible pitfalls of such strategies, and said that his Central Bank is carefully mulling whether such a model would be appropriate for it.

“We still don’t have the major framework to do inflation targeting as such. But we are gently moving toward that eventually,” Cabraal said, adding that it is in the process of getting various data series “into shape.”

“Once that is also there, we would probably look at the possibility of targeting inflation from about 2011 onwards. It’s too early to say yet definitely, but still that is a possibility that we will examine, and give a clearer picture [of] in early 2011,” he said.

He said the bank’s economic research department has looked at the way the Bank of England and other central banks target inflation, and is “right now” working on a “possible way forward.” But he didn’t meet with BOE officials to talk about the plan on this visit to London, he said. Cabraal said he has taken note of the “imperfections” of such an approach, and that it can be impractical to be obsessed by a single number. “Economic management is a lot wider than that,” Cabraal said. “If you get too concerned about a particular figure and then your entire effort is driven towards that number only, you miss out on lots of other things.”

Cabraal also indicated that since his central bank hasn’t cut rates that aggressively on the way down, it can be more relaxed on the way up, but that it has “space” to adjust policy, in the form of interest rates, the statutory reserve ratio or open market operations, if inflation rears its head. It is too soon to say what sequence such moves would come in, he said. Sri Lanka’s benchmark repurchase rate stands at 7.50 percent, while the statutory reserve ratio—the proportion of deposits that banks have to set aside with the central bank—is 7 percent.

Inflation has been rising steadily in recent months due to a sharp increase in food prices and comparison with last year’s muted readings. The consumer price inflation rate in Colombo jumped to 6.5 percent in January from 4.8 percent in December.

“Maybe we will watch for the next couple of months to see how it is faring and if there’s any other risk of inflation pressures coming back again,” Cabraal said.

If officials are satisfied pressures aren’t accelerating, they could leave policy unchanged, he said, but he acknowledged that conditions could change “quite materially” in a short period of time.

“We will then need to take some action,” he said. But “for the time being we’re satisfied with what we’re doing.”

Cabraal tipped “6 percent plus” output growth in 2010, and said it could be quite significantly stronger. The economy is likely to expand “beyond 7 percent” in 2011 if large infrastructure projects happen as planned. An inflation rate of 5 percent to 6 percent should be “achievable” in both 2010 and 2011, he added.

Sri Lanka is already seeing “very clear” benefits from the end of its long-lasting conflict with the LTTE in May last year, with growth in tourism, higher remittances for development, better transportation, more land available for agriculture and more confidence in its cultivation, and greater activity in fisheries with the removal of naval blockades, Cabraal said.

With that improvement in conditions also comes the risk of rapid inflows and later outflows, as global investors seek to make short-term profits. Foreign investment is already on the rise, but the Governor said that the Central Bank is prepared for so-called hot money flows and doesn’t foresee significant problems as a result.

He also indicated that the authorities weren’t inclined to micromanage flows into and out of Sri Lanka, pointing out that they had resisted the temptation to devalue the currency during the crisis to make it more costly for investors to remove their cash.

“That gave a very strong message to the outside world that you can enter Sri Lanka and exit without making a new loss,” Cabraal said, noting that once the crisis eased, all the money that had been withdrawn—and more besides—returned.

“Because we took a long-term view and we said we want investors to feel comfortable with our country, I think it paid extraordinary dividends. So that’s the way we have to reflect on these matters,” he said.

Following the Government’s sale last October of $500 million in sovereign bonds, which was more than 13 times oversubscribed, Cabraal said that Sri Lanka has no immediate plans to issue more bonds overseas, but that it would “certainly” be an option in the future.

“At the time that we do require funds, it would definitely be on the agenda to be examined,” he said, adding that strong international appetite for Sri Lankan paper and quite competitive benchmark and trading rates imply the possibility is “fairly high up” in the list of options for raising money.

London, Dow Jones