Tuesday Aug 18, 2026
Tuesday Aug 18, 2026
Tuesday, 18 August 2026 12:02 - - {{hitsCtrl.values.hits}}
In an article published in the Daily FT on 14 July 2026, I argued that Sri Lanka should not reduce its inflation target from 5% to 2% at the present juncture. The argument was based on the view that the economy remains vulnerable to exchange-rate fluctuations, energy price shocks, supply-side disruptions, elevated debt levels, fragile balance sheets, and external uncertainties. While acknowledging the long-term benefits of low and stable inflation, the article emphasised that the issue is fundamentally one of timing, feasibility, and macroeconomic preparedness.
In a thoughtful response published in the Daily FT on 12 August 2026, Ravi Ratnasabapathy advanced the contrary position. He argued that a lower target, or a 2% ceiling, would strengthen monetary discipline, reduce the risk of inflation overshooting, support lower long-term interest rates, minimise the likelihood of balance-of-payments crises, and enhance the credibility of a rules-based monetary policy framework.
These arguments deserve serious consideration. However, they do not, in my view, alter the central proposition that the appropriateness of an inflation target should be assessed in the context of a country’s macroeconomic conditions, economic structure, and institutional framework, rather than by reference to a universally preferred numerical benchmark.
The purpose of this article is to identify areas of agreement and disagreement with the response article and to clarify the reasoning behind my original position.
At its core, this debate should not be framed as a choice between supporting or opposing low inflation.
There is broad recognition that maintaining a low and stable inflation target is essential for sustainable economic growth, investment, and financial stability. Equally important, however, is ensuring that the target itself remains a credible and durable anchor for expectations. The more relevant question is therefore not whether inflation should be low, but what inflation target best promotes macroeconomic stability and economic welfare under a country’s specific circumstances. That determination cannot be made by reference to a single numerical benchmark alone. The real question is whether reducing Sri Lanka’s inflation target from 5% to 2% at this stage of economic recovery would generate net economic benefits or impose unnecessary adjustment costs.
Monetary discipline is necessary, but inflation dynamics matter
Perhaps the strongest argument advanced in the response article is that sustained inflation cannot be viewed as an exogenous phenomenon. If monetary policy accommodates price shocks through excessive liquidity creation, inflation can become entrenched and expectations can become unanchored. On this point there is little disagreement. Sri Lanka’s recent experience demonstrates the dangers associated with fiscal dominance and excessive monetary expansion.
The real question is whether reducing Sri Lanka’s inflation target from 5% to 2% at this stage of economic recovery would generate net economic benefits or impose unnecessary adjustment costs
However, acknowledging the importance of monetary discipline does not imply that all inflation originates from excessive demand or money growth. In a small open economy such as Sri Lanka, inflation is often influenced by factors beyond the direct control of monetary policy, including exchange-rate movements, energy prices, food supply disruptions, and fluctuations in global commodity markets.
The inflationary episode during the recent economic crisis illustrates this reality. Currency depreciation, external financing constraints, supply shortages, and energy price adjustments all contributed significantly to inflationary pressures. Subsequent inflation movements have likewise reflected a combination of domestic and external influences.
This distinction is important because the choice of inflation target affects how central banks respond to such shocks. A very low target may necessitate a stronger policy response to temporary inflationary pressures, potentially generating unnecessary volatility in output and employment. A somewhat higher target may provide greater flexibility to absorb temporary shocks while preserving medium-term price stability.
The appropriate conclusion, therefore, is neither that short-term price fluctuations and the resulting volatility in inflation are entirely non-monetary nor that they are solely monetary in origin. In a small open economy, such movements often reflect a combination of monetary, supply-side, and external factors. Monetary policy remains responsible for anchoring inflation over the medium term, but the choice of target, tolerance band, and policy horizon should also reflect the economy’s exposure to supply shocks, exchange-rate pass-through, and the process through which expectations are formed.
Transition costs of disinflation deserve greater attention
A credible low-inflation target environment can, over time, reduce inflation risk premia, improve financial planning, lower nominal interest rates, and support more efficient allocation of capital. There is little disagreement on this point. The issue is not whether low inflation is desirable in the long run, but how an economy moves from one inflation target to another, and at what cost.
Reducing Sri Lanka’s inflation target from 5% to 2% would not be a mere technical adjustment. It would represent a material lowering of the economy’s nominal anchor. Such a shift would require monetary policy to convince households, firms, financial markets, and wage setters that inflation will not only decline toward the lower target but remain durably anchored around it. Depending on prevailing macroeconomic conditions, that process could require tighter monetary conditions, higher real interest rates, slower credit growth, and weaker aggregate demand during the transition.
This distinction between the eventual steady state and the path toward it is crucial. The argument for a 2% target is strongest when it describes the benefits of a well-established, credible, low-inflation target regime. It is less complete when it gives insufficient attention to the adjustment required to reach that regime from Sri Lanka’s current position.
Sri Lanka is not considering this question from a position of normalcy. The economy is still emerging from a severe crisis, with external vulnerabilities, public debt pressures, balance-sheet repair, and exposure to imported inflation still shaping the policy environment. Recent central bank projections have already indicated that inflation may remain above the current target in the near term before converging back toward it. That is precisely the type of environment in which target design, policy horizon, and communication matter greatly.
A premature shift to 2% could create two risks. If monetary policy tightens sufficiently to achieve the new target quickly, the economy may face unnecessary output, investment, and employment costs. If policy does not tighten enough, the new target may be missed early, weakening rather than strengthening credibility. In either case, the credibility gain from announcing a lower number is not automatic.
Flexibility and credibility are not opposites
A more fundamental difference between the two perspectives concerns the relationship between credibility and flexibility. The response article suggests that flexibility weakens predictability and therefore undermines credibility.
Modern monetary economics generally does not support such a stark distinction. Contemporary inflation-targeting frameworks are commonly described as flexible inflation targeting because central banks are expected to stabilise inflation while also avoiding unnecessary fluctuations in output and employment.
Credibility arises not from rigid adherence to a numerical target irrespective of circumstances, but from public confidence that the Central Bank will consistently pursue price stability over the medium term. A framework that forces policymakers to react aggressively to every temporary inflation shock is not necessarily more credible than one that permits measured responses while maintaining a clear commitment to the inflation objective.
The argument for a 2% target is strongest when it describes the benefits of a well-established, credible, low-inflation target regime. It is less complete when it gives insufficient attention to the adjustment required to reach that regime from Sri Lanka’s current position. Sri Lanka is not considering this question from a position of normalcy. The economy is still emerging from a severe crisis, with external vulnerabilities, public debt pressures, balance-sheet repair, and exposure to imported inflation still shaping the policy environment
Indeed, many successful inflation-targeting central banks place considerable emphasis on communication, accountability, and medium-term policy horizons rather than mechanical adherence to short-term inflation outcomes. Flexibility, when exercised within a transparent and disciplined framework, can enhance rather than diminish credibility.
The debate, therefore, is not between rules vs. discretion. It is between disciplined flexibility vs. rigid policy responses that may prove counterproductive in a volatile economic environment.
The response article is correct in warning that excessive discretion can undermine credibility, particularly in emerging economies with histories of high inflation. However, preserving a degree of policy flexibility in a shock-prone economy is entirely consistent with modern inflation-targeting practice and need not come at the expense of credibility.
Growth and inflation should not be confused
A second important issue concerns the relationship between inflation, interest rates, and economic growth. Sustainable economic growth cannot be created by money creation, artificially low interest rates, or tolerance of inflation. No serious case for retaining a certain level of inflation target should be interpreted as a defence of inflationary stimulus. Sri Lanka’s long-term growth prospects depend on productivity, investment efficiency, export competitiveness, policy consistency, sound public finances, human capital, and institutional quality.
However, recognising the limits of inflationary growth does not mean ignoring the economic costs of reducing inflation too quickly. While monetary policy cannot permanently increase economic growth, it can affect investment, credit, employment, and overall economic activity in the short to medium term. If achieving a lower inflation target requires prolonged tight monetary policy, the adjustment burden may fall on businesses and households that are still recovering from the recent economic crisis.
The objective of flexible inflation targeting is to preserve medium-term price stability while avoiding unnecessary fluctuations in output and employment. This is not a concession to inflation; it is a recognition that monetary policy operates under uncertainty and that not all inflation shocks are alike. A demand-driven inflationary boom requires a different response from a temporary rise in prices caused by imported fuel, food supply disruptions, or exchange-rate pass-through.
The correct policy distinction, therefore, is not between “inflation for growth” and “low inflation at any cost.” The proper distinction is between unsound monetary expansion, which should be firmly rejected, and a realistic inflation target that avoids avoidable economic losses while maintaining a credible medium-term anchor.
Sri Lanka should not view inflation as a development strategy. Nor should it adopt an inflation target that could impose significant disinflation costs before the economy has rebuilt the resilience, financial depth, and fiscal and external buffers needed to sustain it.
Acknowledging the importance of monetary discipline does not imply that all inflation originates from excessive demand or money growth. In a small open economy such as Sri Lanka, inflation is often influenced by factors beyond the direct control of monetary policy, including exchange-rate movements, energy prices, food supply disruptions, and fluctuations in global commodity markets. The inflationary episode during the recent economic crisis illustrates this reality
Exchange-rate flexibility and limits of stability
The response article correctly highlights the costs of exchange-rate depreciation. In an import-dependent economy, depreciation raises the domestic cost of fuel, food, medicine, capital goods, and intermediate inputs. It can erode real incomes, intensify inflationary pressure, and complicate foreign-currency debt servicing. Nor does nominal depreciation provide a durable improvement in competitiveness unless it is accompanied by productivity growth, export diversification, and structural reform.
These concerns are valid. But they do not imply that exchange-rate stability should be treated as an overriding policy objective. The Central Bank of Sri Lanka Act, No. 16 of 2023, requires the Monetary Policy Board to implement a flexible exchange rate regime consistent with the flexible inflation-targeting framework, with the objective of achieving and maintaining domestic price stability. In a small open economy, the exchange rate plays an important adjustment role. When external shocks occur, a flexible exchange rate can help absorb part of the adjustment that might otherwise fall entirely on foreign exchange reserves, interest rates, import compression, or administrative controls.
The relevant choice is therefore not between exchange rate depreciation and stability, but between flexibility and costly attempts to defend a particular exchange-rate path.
Excessive resistance to exchange-rate movements can deplete foreign exchange reserves, tighten financial conditions, encourage speculative pressures, and recreate the vulnerabilities that contributed to past external crises. For a country such as Sri Lanka, where reserve buffers remain limited relative to potential external financing needs and external shocks, attempting to defend a particular exchange-rate level for a prolonged period may neither be feasible nor sustainable. On the other hand, excessive volatility can destabilise prices and expectations. The policy challenge is to strike the right balance.
A very low inflation target would make this balance more difficult. If imported inflation rises because of fuel prices, food prices, or exchange-rate pressure, a 2% target would leave less room to distinguish between temporary first-round price effects and persistent inflationary pressure. The Central Bank could be forced either to tighten sharply in response to supply-side pressures or to rely more heavily on foreign-exchange intervention to contain inflation. Neither response is costless.
For a country still rebuilding reserves and external confidence, exchange-rate flexibility remains an important part of the adjustment mechanism. It should not be used casually, and depreciation should never be treated as a substitute for reform. But a monetary framework that allows some space to absorb external shocks is likely to be more robust than one that makes every temporary imported price increase a test of credibility.
The correct policy distinction, therefore, is not between “inflation for growth” and “low inflation at any cost.” The proper distinction is between unsound monetary expansion, which should be firmly rejected, and a realistic inflation target that avoids avoidable economic losses while maintaining a credible medium-term anchor
Risks to debt sustainability should not be ignored
The response article also raises a legitimate warning against using inflation to reduce the real burden of debt. That warning is important. Inflationary finance is not a sustainable debt-management strategy, particularly for a country with foreign-currency obligations, a history of exchange-rate instability, and a continuing need to rebuild investor confidence.
Yet the response article appears to assume a stronger claim than the original article makes. The original article does not recommend using inflation to liquidate debt; it argues that a lower inflation path can reduce nominal GDP growth. If achieving that lower path requires higher real interest rates, the debt-service burden may increase, especially during a fragile recovery.
This is not an argument for inflating away debt. It is a recognition of standard debt arithmetic. Given that Sri Lanka’s public debt remains large relative to the size of its economy, the timing and pace of disinflation matter. A sudden move to a much lower inflation target could tighten financial conditions before fiscal buffers, growth momentum, and external reserves are sufficiently strong. That could make the adjustment harder, not easier.
The balanced position is clear. Sri Lanka should not rely on inflation to manage its debt burden. Fiscal consolidation, revenue reform, expenditure discipline, growth-enhancing structural reforms, and credible debt management are essential. At the same time, the macroeconomic consequences of a rapid shift to a 2% inflation target should not be dismissed. Price stability and debt sustainability must reinforce each other. They should not be placed in unnecessary tension through premature target reduction.
Question of sequencing rather than principle
The disagreement is ultimately less about principle than about sequencing. Both sides of the debate support price stability, central bank independence, fiscal discipline, credible monetary policy, and the avoidance of inflationary finance of public debt. The difference lies in how best to secure those objectives under Sri Lanka’s current conditions.
One view is that adopting a lower inflation target would itself strengthen credibility. The alternative view is that credibility is earned through consistent performance, institutional strengthening, fiscal discipline, transparent communication, a resilient external position, and a monetary policy framework that can withstand real-world shocks.
If imported inflation rises because of fuel prices, food prices, or exchange-rate pressure, a 2% target would leave less room to distinguish between temporary first-round price effects and persistent inflationary pressure. The Central Bank could be forced either to tighten sharply in response to supply-side pressures or to rely more heavily on foreign-exchange intervention to contain inflation. Neither response is costless
This distinction matters. A target that is too high may eventually weaken purchasing power and reduce the ambition of policy. But a target that is too low for current conditions may also damage credibility if it is repeatedly missed or achieved only at excessive real-economy cost. The optimal target is not necessarily the lowest target. It is the target that can credibly anchor expectations while remaining consistent with the economy’s structure, shock exposure, and institutional capacity.
Sri Lanka should therefore approach target revision as a structured policy review rather than a symbolic commitment to a lower number. Such a review should examine inflation persistence, exchange-rate pass-through, expectation formation, monetary transmission, fiscal risks, financial-sector resilience, and the output cost of disinflation.
The question is not whether Sri Lanka should aspire to lower and more stable inflation. It should. The question is whether an immediate move from 5% to 2% is the right next step in that journey.
Conclusion
The case against an immediate reduction of Sri Lanka’s inflation target from 5% to 2% should not be misconstrued as a defence of higher inflation, as implied in the response article. Nor does it reflect any reluctance toward monetary discipline. Rather, it is an argument that the inflation target should be aligned with the economic realities and conditions of the economy expected to achieve it.
A credible inflation target is not necessarily the lowest possible target. It is one that is well understood by the public, can be achieved consistently by the Central Bank, and can be sustained by the economy without imposing disproportionate costs. For Sri Lanka, this requires careful consideration of external vulnerabilities, supply-side shocks, exchange-rate pass-through, debt dynamics, financial-sector conditions, and the evolving post-crisis policy environment.
This does not imply that the current target should remain unchanged indefinitely. As macroeconomic stability becomes more firmly established, inflation expectations become better anchored, debt vulnerabilities recede, external buffers strengthen, financial markets deepen, and the economy becomes more resilient to shocks, the case for a lower inflation target may become increasingly compelling.
(The author currently serves as an Assistant Governor of the Central Bank of Sri Lanka (CBSL). The views expressed in this article are his own and do not necessarily reflect those of the CBSL. The author may be contacted at [email protected] for further information.)
