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Monetary Targeting
As Griffiths and Wood (1981) point out, monetary targeting, that is, the
adoption of quantitative targets for the rate of growth of the money supply as
the basis of monetary policy, began in the 1970s in industrialised countries.
Monetary targeting was adopted as a mechanism to bring the chronic high
inflation and fluctuations in output at the time under control, as controlling
interest rates and credit conditions, which had up to then been the practice,
had failed in this regard.
The ultimate objective of the conduct of the monetary policy by the Central
Bank of Sri Lanka is to regulate monetary conditions and price developments.
It has evolved gradually over the past sixty six years. Under the fixed
exchange rate regime that was in place until 1977 as well as during the
period of the managed floating exchange rate regime that existed until the
adoption of a floating exchange rate in 2001, the exchange rate played a key
role in anchoring inflation expectations.
Inflation Targeting
It is characterized by,
An announced numerical inflation target
An inflation forecast, which facilitate forward looking monetary
policy decision making
High degree of transparency and accountability
Inflation targeting central banks exhibit anti-transparency, contrary to the
commonly accepted view that inflation targeting central banks are highly
transparent.
This is most explicit in the inflation targeting framework suggested by
Svensson (1997), he explains that, in the case of an inflation targeting central
bank, while the decision as to how rapidly inflation should be brought back to
the desired rate after some departure from it depends on the strength of the
central banks preferences with respect to inflation vis--vis its other
objectives, it is not common for inflation targeting central banks to be explicit
about the level of output or employment that they regard as desirable or the
weights they attach to such objectives.
In this regard, it is pertinent to point out that Svensson (2005) in fact states
that inflation-targeting central banks can make substantial additional
FIT aims at stabilising both inflation around the inflation target, and the real
economy, whereas strict IT aims at stabilising only inflation, with little regard
to the stability of the real economy. (Svensson, 2009).
Under this framework, the Consumer Price Index (CPI) based inflation is
targeted to be
below 6 per cent in January 2016
4 per cent for 2016-2017 with a band of +/- 2 per cent.
Further, subject to the establishment and achievement of the nominal anchor
in terms of an inflation target, monetary policy conduct is expected to be
consistent with a sustainable growth trajectory and financial stability.
Root-causes to move away from MT to FIT framework
The following integral determinants have been encountered by the Central
Bank of Sri Lanka to move away from MT frameworks, and aligning it with a
FIT framework.
MT frameworks weakening relationship between money supply
and inflation.
Given the rising volatility in money multiplier and velocity, the
role of monetary targets as a nominal anchor has become
uncertain and also complicated the Central Banks communication
strategy.
Enhanced Monetary Policy Framework in Sri Lanka
The Central Bank of Sri Lanka conducts its monetary policy within an
enhanced monetary policy framework with features of both MT and FIT
frameworks as interim arrangement.
implicit GDP deflator of 5.0 per cent, while the average growth
was set at 12.0 per cent.
In comparison to this envisaged monetary expansion, the actual
broad money growth in 2015 averaged 15.2 per cent, although an
immediate threat to inflation was not observed due to favourable
supply conditions.
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MONETARY POLICY, MONEY, CREDIT AND
INTEREST RATES
MONETaRY POLICY, MONEY, CREDIT AND INTEREST RATES
CENTRAL BANK OF SRI LANKA | ANNUAL REPORT 2015
200
7
flows as well as the weak financial position of
certain public corporations. Excess rupee liquidity
in the domestic money market, although declined
from the levels observed in the previous year,
remained high reflecting accommodative monetary
conditions in the economy. The Central Bank
conducted open market operations appropriately to
guide short term interest rates in the money market.
Both deposit and lending rates remained relatively low
during 2015 although yield rates in the government
securities market increased responding mainly due
to the high domestic borrowing requirement of the
government, amidst the Central Banks decision
to issue government securities only through public
auctions. In the meantime, headline inflation declined
further during the year mainly as a result of downward
revisions to administered prices of key commodities,
favourable domestic supply side developments and
declining prices in international commodity markets.
Nevertheless, core inflation displayed an upward
trend since February 2015 reflecting the firming up of
demand conditions.
Although an immediate threat to price stability
is not expected, the Central Bank commenced
tightening its monetary policy stance gradually
from end 2015 in order to forestall excessive
demand pressures on inflation arising from
high credit and monetary expansion and the
continued high excess rupee liquidity in the
domestic money market. Accordingly, the Central
Bank raised the Statutory Reserve Ratio (SRR)
applicable on all rupee deposit liabilities of licensed
commercial banks (LCBs) by 1.50 percentage
points in December 2015, to be effective from
16 January 2016. This measure was expected
to permanently absorb a part of excess liquidity
from the market. Furthermore, the Central Bank
increased its main policy interest rates, namely
the Standing Deposit Facility Rate (SDFR) and the
Standing Lending Facility Rate (SLFR) by 50 basis
points effective from the close of business on 19
February 2016. Reflecting these policy changes
as well as continued demand for credit, overnight
interest rates, which remained close to the lower
bound of the policy rate corridor since March
2015, increased to the upper half of the corridor,
while yields on government securities increased
substantially and other market interest rates also
commenced moving upwards. Going forward,
amidst volatile global economic conditions and
domestic vulnerabilities, the conduct of monetary
policy in 2016 will be focused on maintaining
inflation in mid-single digits, while facilitating the
economy to realise its potential in the medium term