Monetary policy relaxation amidst economic recovery

Last month, the Monetary Policy Board (MPB) of the Central Bank (CB) decided to further soften its monetary policy stance and established the newly introduced Overnight Policy Rate at 8%. The new development represents the Monetary Authority evolving towards a single policy interest rate mechanism from its earlier dual policy interest rate framework. As per the Bank, this transition is expected to enhance the efficiency and effectiveness of monetary policy signalling and transmission to the financial markets and the broader economy.

The deeper-than-expected deflation conditions in the near-term with further moderation of underlying inflationary pressures and inflation expectations had been one of the prime reasons behind the MPB’s latest monetary policy decision. Headline inflation, as measured by the year-on-year change in the Colombo Consumer Price Index (CCPI), recorded a deflation of 2.1% last month compared to the deflation of 0.8% last October. For a country which was featured in the international news media two years ago for its galloping inflation (the inflation was hovering around 70% in September 2022), the decline in the overall consumer price level represents a remarkable turnaround. 

The illustrious economist Milton Friedman once declared that inflation is always and everywhere a monetary phenomenon. Prior to the tenure of Nandalal Weerasinghe, the members of previous Monetary Boards took monetary policy decisions in contravention of this well-accepted, fundamental theory in monetary economics. Nevertheless, soon after the appointment of Weerasinghe as the CB Chief in April 2022, the then Monetary Board raised the policy rates by a substantial margin to bring down inflation and maintain and achieve price stability, which represents the fundamental obligation of a monetary authority. The aforementioned increase in the policy rates were followed by further rate hikes on several occasions later. 

The cut in interest rates would no doubt embolden the hearts of businessmen, holders of financial assets like equity as well as bonds. When the CB was tightening the monetary policy, the lending rates went as high as 30 to 36%, much to the fury of SMEs and industrialists. But now it is the turn of depositors and pensioners to express their rage over the reduction in interest rates paid on their deposits. In fact, the reduction in fixed deposit rates provided an opportunity for politicians to woo the votes of senior citizens in the run up to the Presidential election and the NPP promised a 5% extra interest rate for the deposits of individuals who are 60 and above. It would be interesting to see whether the ruling party would live by their word and grant an additional interest rate to elderly citizens from the next Budget.

Meanwhile, during the press briefing which was held to elaborate on the latest rate cut, the CB Governor projected that the island’s economy would grow by 4.5% to 5.0% in 2024 while predicting an expansion of above 3% in 2025. However, the truth of the matter is the growth is coming from a very low base as the economy contracted in both 2022 and 2023. At a public event two months ago, Director – Institute of Policy Studies Dr. Dushni Weerakoon pointed out that output levels still remain significantly lower than what they were in 2018 and 2019.

The new Central Bank Act of Sri Lanka, which was enacted in 2023, has provided a greater degree of autonomy to the Monetary Authority to accomplish its core objective of maintaining price stability. It must be recalled that when this law was enacted in the legislature, the then three NPP MPs, including the current President voted against it. Also, their economic policy statement – Framework for Economic Renaissance – pledged to maintain pro-economic growth policy interest rates, raising question marks over the conduct of the monetary policy.

It is imperative for the Government to provide a free hand to the CB in terms of setting the policy rate disregarding their pre-election rhetoric on determining interest rates which lacked any substance.