Lowering CBSL’s inflation target from 5% to 2% is desirable for economic stability

Debunking economic myths # 3

An opinion is cropping up in the political circles that the current inflation target to be achieved by the Central Bank of Sri Lanka (CBSL), in terms of the Central Bank Act No. 16 of 2023 (CBA), is too high and therefore, it should be reduced to a more appropriate level to achieve economic stability. Accordingly, it is suggested to lower the CBSL’s inflation target from 5% to 2% at the upcoming review of the monetary policy framework in October.

While a lower inflation is undoubtedly beneficial to prevent erosion of real incomes and to sustain economic stability, this suggestion needs to be considered carefully in the broader context of economic realities in a developing economy like Sri Lanka. 

Inflation targeting

As per the CBA, the Monetary Policy Board of the CBSL is responsible for formulating monetary policy and implementing a flexible exchange regime in line with the Flexible Inflation Targeting (FIT) framework. Section 26(1) of the CBA stipulates that the Minister of Finance and the CBSL are required to sign a Monetary Policy Framework Agreement (MPFA) with regard to setting out the inflation target to be achieved by the CBSL. 

The current MPFA, published in the Government Gazette of October 5, 2023, mandates the CBSL to maintain the quarterly headline inflation at the target rate of 5% with a margin of ±2 percentage points. In pursuance of the CBA, the inflation target and other relevant parameters are required to be reviewed once in every three years, and the first review is due in October this year. 

Arguments for low inflation target

A main argument expressed by the proponents of a low inflation target is that it protects the purchasing power of money, thus preventing a deterioration of wages, savings, and wealth in real terms. It is also argued that an official commitment to maintain low inflation irons out inflationary expectations that would lead to wage-price spirals and arbitrary price increases. Low inflation reduces market uncertainties and enables entrepreneurs to make long-term investment decisions efficiently without fearing unanticipated cost escalations in the future. The ability to protect the livelihoods of the extremely poor by maintaining stable consumer prices is a further benefit of a low inflation target.

Self-contradictory opinions

The suggestion to impose a lower inflation target prompts revisiting the MPFA from a different perspective. 

But the self-contradictory views expressed by the proponents negate their own recommendation. A core argument put forward by them is that a minimal inflation target is necessary to deal with Sri Lanka’s impending stagflation, characterised by high inflation, slow GDP growth, and high unemployment. However, it should be noted that their recommendation for a low inflation target calls for an aggressive contractionary monetary policy stance that requires an increase in interest rates. Thus, it will retard economic growth and aggravate unemployment, nullifying the very purpose of lower inflation targeting.

Some proponents of low inflation target admit that Sri Lanka’s inflation is largely driven not by demand-driven factors but by supply- side factors such as exchange rate depreciation, fuel cost escalation, and food price increases. Therefore, they argue that excessive reliance on interest rate adjustments alone may not address the root causes of inflation. In such a situation, lowering the inflation target to attain price stability, as suggested by them, does not make sense.

Headline vs. core inflation

Headline inflation measures the overall price movements in an economy, covering the entire consumer basket of goods and services. In contrast, core inflation is a measurement that excludes items that are subject to volatile price fluctuations, such as food and energy. Policymakers watch both indices. The headline inflation is useful to understand the impact of overall price fluctuations on households and businesses. However, it is highly sensitive to short-term shocks such as sudden global oil price hikes or supply chain disruptions caused by adverse weather conditions. 

The core inflation, which filters such shocks, provides a clearer indication of underlying inflation rather than a temporary “noise”, and therefore, it is frequently used for monetary policy purposes.   

However, it is the headline inflation that should be targeted in conducting monetary policy, in terms of the MPFA. A main limitation of this rule is that the CBSL is bound to maintain a headline inflation target that includes temporary price fluctuations arising from supply-side shocks, which are beyond the scope of monetary policy. 

Therefore, adequate leeway should be given to the CBSL to allow for such inflationary pressures arising from factors beyond its control. An extremely low, rigid inflation target of 2% suggested by the critics will not provide such policy space. 

Supply-side shocks

Sri Lanka’s inflation is highly sensitive to supply-side shocks since it is a small, import-dependent economy that is heavily exposed to global commodity price fluctuations, foreign exchange vulnerabilities, and weather-related agricultural production disruptions. 

For instance, the year-on-year headline inflation rose from 2.2% in March 2026 to 5.4% in April and to 5.5% in May, largely reflecting the oil price increase caused by the tensions in the Middle East. However, the core inflation showed a lower increase from 2.5% in March to 3.8% in April and to 3.9% in May. These movements reflect that the price increases arising from supply-side shocks, which are beyond the control of the CBSL, contributed much to the recent inflation hike. Therefore, it is advisable to keep the inflation target at a moderate level of 5%, instead of reducing it to a minimum level, as recommended by the critics. 

Choice of optimum inflation target 

There is no unique scientific basis to choose an optimal inflation target, which is not a magic number. Rather, it is a pragmatic, research-based policy anchor chosen by governments and central banks. The numerical inflation targets adopted by the central banks differ from country to country, depending on factors such as inflation drivers, structural characteristics, growth potential, and resilience to external shocks. 

Advanced economies like the US, Canada, UK, European region, and New Zealand typically use a tighter inflation target of around 2-3% with price stability as their overriding goal. But for a developing country like Sri Lanka, it is prudent to continue using the present inflation target of 5% with a margin of ±2 percentage points for achieving the primary objective of price stability since such flexibility provides leeway to the CBSL to factor in supply-generated inflationary pressures. 

(The author, Emeritus Professor in Economics at the Open University of Sri Lanka, is the President of the Sri Lanka Economic Association and the Honorary Deputy Chairman of the Gamani Corea Foundation)