Nearly two years of missed inflation targets: why that matters

Central Bank Governor Dr. Nandalal Weerasinghe  

Headline inflation in Sri Lanka has been below 3% for seven consecutive quarters, 

persistently missing the Central Bank’s target of 5% and 

breaching the margin that 

triggers formal accountability to Parliament. Five successive deviation reports have been filed. This article explains why a prolonged miss matters, what it does to the credibility of the monetary policy framework, and what options exist going forward

What the framework is and what it requires

An inflation target is a coordination device, not a forecast. When firms set prices, workers negotiate wages, and banks price loans, they do so based on where they expect inflation to be. If they believe the central bank will deliver on its commitment, they price accordingly, and the target becomes partly self-fulfilling. When the target is not believed, every shock feeds directly into prices because there is no expectation anchor to absorb it. The bank must adjust rates more aggressively, hold them longer, and accept more damage to output, to achieve the same result.

The Central Bank of Sri Lanka Act, No. 16 of 2023, establishes a clear hierarchy of objectives built around this logic. Section 6(1) makes domestic price stability the primary object. Section 6(2) makes financial system stability the ‘other’ object. Section 6(3) requires the Central Bank to support the Government’s broader economic policy, but only “without prejudice to the attainment of its objects” and “subject to the provisions of this Act.” Output stabilisation is not a co-equal objective; Section 6(4) treats it as a consideration to be taken into account “in pursuing” price stability. This hierarchy is not incidental. It is the reason the Act exists in its current form.

The 5% target was set in the Monetary Policy Framework Agreement (MPFA) signed between the Central Bank and the Minister of Finance in October 2023, under Section 26 of the Act, consistent with the medium-term inflation path projected under the International Monetary Fund (IMF)-supported program. The MPFA specifies a margin of plus or minus 2 % points for the purpose of accountability: if quarterly headline inflation falls below 3% or exceeds 7% for two consecutive quarters, the Monetary Policy Board must report to Parliament on the reasons for the miss, the remedial actions it proposes, and a timeline for returning to target. Quarterly headline inflation has been below 3% since the second quarter of 2024, and has remained below the margin through the end of 2025. Credibility has a legal foundation, not an aspirational one, and the Act’s accountability architecture is now being tested in sustained fashion.

What happens when the target stops working

When a target is missed persistently, expectations shift from tracking the target to tracking recent experience, and the target’s coordination function weakens. The Central Bank’s own data trace the shift. Its February 2025 Monetary Policy Report noted that inflation expectations were “well below the inflation target of 5% across tenors.” By August 2025, short-term corporate expectations were moving “broadly in line with realised inflation,” precisely the backward-looking pattern a credible target is supposed to prevent. By February 2026, medium-term expectations had begun converging back toward 5%, an encouraging sign, but a fragile one after seven quarters outside the margin.

The risk is not only that inflation is too low today. It is that the next time inflationary pressure emerges, the Central Bank will have to raise rates further and hold them longer because expectations are no longer helping. Rebuilding the anchoring function of a target is far harder than maintaining it, and whether the Central Bank was right to look through the miss depends on whether expectations were still anchored when it made that choice.

Central banks are routinely advised to “look through” temporary supply shocks, and Sri Lanka has experienced genuine supply-side disinflation (falling prices driven by lower input costs, particularly energy, rather than by weak demand). That advice is sound when expectations remain anchored. When they are not, inaction risks validating a shift in expectations rather than waiting it out. The question is not whether the supply shock is real but whether expectations are anchored at the time the central bank decides to look through it. When output gap estimates (the gap between what the economy is producing and what it could produce at full capacity) are also uncertain, as they typically are after a structural break (a large, lasting change in the economy’s structure, such as Sri Lanka’s 2022 crisis), the inflation data themselves become the strongest signal of underlying demand conditions. Seven quarters below 3% cannot easily be dismissed as noise, and the consequences of a weakening anchor are amplified in a shallow foreign exchange market.

These credibility dynamics are especially consequential in Sri Lanka’s foreign exchange market. Inflation targeting works best when financial markets are deep and liquid. In Sri Lanka’s foreign exchange market, low turnover and few participants mean that even modest shifts in expectations can produce outsized exchange rate movements. Central banks in this position face legitimate concerns about exchange rate volatility, and those concerns can lead them to hold rates higher than the inflation target alone would warrant. The international evidence, though, suggests that this response is self-defeating.

Sri Lanka’s current monetary policy stance resembles the pre-global financial crisis emerging market pattern that the IMF’s October 2025 World Economic Outlook (WEO) identifies as costly. Studying 26 emerging markets over nearly three decades, the WEO documents what happens as inflation targeting frameworks mature. Exchange rate pass-through to consumer prices fell by roughly three quarters between the periods before and after the global financial crisis, and central banks stopped responding to exchange rate movements when setting interest rates, because anchored expectations made depreciations less threatening. Yet Sri Lanka holds rates steady while inflation remains well below target, citing external sector risks as a constraint. If credibility is what allows a central bank to operate a flexible exchange rate and an independent monetary policy simultaneously, weakening it now raises the cost of every future shock, and the question becomes what to do about it.

What to do about it

A common objection to easing monetary policy is that it would put pressure on the exchange rate or on credit growth. But a single policy rate cannot simultaneously target inflation, the exchange rate, and financial stability. Jan Tinbergen established a principle that remains foundational in policy design: you need at least as many policy tools as you have policy goals. Any economy simultaneously facing inflation, exchange rate, and credit stability concerns will struggle to address all three with a single policy rate. The design of the Act reflects this logic. Section 66 enumerates fifteen macroprudential instruments, regulatory tools that manage financial stability risks without changing the policy rate, including loan-to-value caps, debt-service-to-income limits, and sectoral capital requirements. Separately, Sections 32 and 33 give the Monetary Policy Board authority to set differentiated reserve ratios by class of deposit liability, which would allow higher requirements on foreign currency liabilities to address exchange rate pressures through a channel distinct from the policy rate. The Act already provides the instruments; the question is whether to use them.

There are three broad options:

• The first is to pursue the target as set: use the policy rate for its primary purpose and deploy macroprudential tools for other concerns separately, as the hierarchy of the Act and the Tinbergen principle both suggest. 
• The second is to amend the Act itself to give other objectives, such as external stability, an explicit role alongside price stability. Beyond the difficulty of legislative change, this option fails to set a clear target. When a framework asks a central bank to pursue multiple objectives simultaneously, firms and households cannot know which one will take priority at any given moment, and expectations cannot anchor to a target that is ambiguous by design. 
• The third option, revising the target itself, requires the most caution. The MPFA can be reviewed under Section 26(4) every three years, or earlier if exceptional circumstances warrant it. But lowering the target because inflation has undershot it is qualitatively different from the other two options. If a central bank moves its target toward wherever inflation happens to be, the target becomes a description of outcomes rather than a commitment to deliver them. Any future target would carry the same question: will they move this one too? If the target is to be changed, it should be for reasons grounded in a reassessment of steady-state inflation, not as a response to the current miss.

None of these options is being pursued.

The greatest risk is that the deviation reports become routine. Section 26(5) requires each report to set out not only the reasons for the miss but also the remedial actions the Central Bank proposes to take and a timeline for returning to target. The first deviation report, filed in December 2024, committed to returning inflation within the target margin by the third quarter of 2025; successive reports have pushed that date further out, to the fourth quarter of 2025 and then to the first quarter of 2026. Across four deviation reports, policy rates were reduced by only 25 basis points. No new remedial action has been proposed, whether through the policy rate or the macroprudential instruments the Act provides. Each report has met the letter of Section 26(5); none has changed the course of policy.

When the accountability mechanism the Act created becomes a formality, the inflation target loses its force as a coordination device, and the costs of restoring credibility fall on future output and interest rates. Seven quarters into a persistent miss, the question is not who is to blame, but which path forward gives monetary policy its best chance of anchoring expectations to the target again.

(The author is an Associate Professor of Financial Economics at Oberlin College and a Global Academic Fellow at Verite Research. [email protected])

The article draws on the analysis shared by Verité Research at its recent bi-annual Public Finance Lounge held in February 2026.