5% or lower? Economists weigh credibility, supply factors in inflation target debate

• Say 5% target missed for eight consecutive quarters 
• Parliament not asking good questions to rectify problem
• Loss of inflation anchoring can keep real interest rates elevated 

Amid debate over whether Sri Lanka should lower its 5% inflation target, economists highlighted the competing considerations surrounding monetary policy, with Verité Research Executive Director Dr. Nishan de Mel arguing that the immediate credibility test was whether the Central Bank of Sri Lanka (CBSL) delivered whatever target it formally committed to, while Advocata Institute Chairman Murtaza Jafferjee stressed the heavy influence of food, energy, and supply-side factors on domestic inflation.

Speaking at a panel discussion on ‘Sri Lanka’s Future: Forecast, Scenarios and Challenges,’ organised by the Sri Lanka – Korea Business Council, Dr. de Mel responded to the proposition that a lower inflation target could be desirable by drawing a distinction between deciding the appropriate target and delivering the one already agreed.

“Once you get into a gazetted agreement with the Government about inflation, you have to meet that. There is no management discretion here. These are the simple facts of accountability and competence,” he said.

Dr. de Mel said the CBSL had missed its 5% inflation target by more than 200 basis points (bps) for eight consecutive quarters. The target was established under the post-crisis monetary framework, which granted the CBSL greater autonomy, while Sri Lanka’s debt sustainability projections were also constructed on the assumption that inflation would be managed at around 5%.

He rejected the proposition that undershooting should be regarded as acceptable simply because inflation was low, arguing that repeated misses had implications for the credibility of the target and the anchoring of expectations.

Dr. de Mel said the framework provided for explanations when inflation deviated sufficiently from target, similar to arrangements governing the Bank of England, but argued that Parliamentary scrutiny had not been strong enough.

“We haven’t been able to get Parliament to ask good enough questions to rectify the problem. So it keeps getting missed and it’s getting a little bit complicated,” he said.

The cost of missing the target extended beyond accountability, Dr. de Mel said, as the credibility of the CBSL’s commitment influenced how businesses and financial markets formed inflation expectations.

“When inflation is anchored on the expectations set by society, it just becomes that without having to do very much and without having to raise interest rates too much,” he said.

Conversely, when markets did not believe the CBSL would deliver its stated inflation objective, subsequent inflation could require a stronger interest-rate response.

“This is a very, very high cost, the loss of trust,” Dr. de Mel said.

He argued that market pricing provided a better indication of credibility than expressions of confidence in the CBSL by private sector participants.

“The high real interest rates that we are asking is a sign that the markets don’t trust that inflation is anchored. That’s the problem we try to solve, but we haven’t solved it yet,” he said.

Lower real rates were important for business investment, Dr. de Mel said, pointing to India’s combination of lower inflation and lower interest rates as a competitive advantage and arguing that Sri Lanka needed to create conditions for businesses to borrow at lower rates.

The inflation outcome also had implications for Sri Lanka’s post-default debt arithmetic.

Dr. de Mel said the actual Government securities yield curve was around 300 bps above the trajectory envisaged in the debt framework, while inflation had remained substantially below the assumed path.

Low inflation combined with high nominal interest rates had pushed real interest rates to among the highest in the region and increased the effective cost of domestic debt, he said.

“When we get inflation wrong, when we get the yields wrong, we are in the wrong terrain for debt sustainability,” Dr. de Mel said. “These have real consequences and I don’t think we should take them lightly.”

Not all deviations from the original economic trajectory had been adverse. Growth had exceeded earlier projections and current account outcomes had been substantially stronger than forecast, while exchange rate movements also affected debt dynamics. Higher yields and lower-than-assumed inflation, however, worked in the opposite direction.

Jafferjee brought a different consideration to the discussion, highlighting the composition of Sri Lanka’s inflation and the limits of conventional demand-side monetary policy in addressing some of its largest drivers.

He said inflation was heavily influenced by food prices, where exposure could not easily be reduced without structural changes, and by energy prices.

“The thing is that our inflation is heavily influenced by food, which we really can’t protect unless we make structural differences, and energy prices. That has a huge impact,” Jafferjee said.

He said conventional demand-side inflationary pressures also took time to work through the economy.

“These classical demand-side inflationary pressures, it takes a bit of time to really play out,” he said.

Jafferjee also cautioned against attributing inflation of around 2% simply to monetary policy, pointing to base effects as well as the influence of food and energy.

His comments highlighted the importance of food, energy, and supply-side factors in assessing Sri Lanka’s inflation performance, alongside conventional demand-side pressures.

For Dr. de Mel, however, the question of what level Sri Lanka ultimately chose as its inflation target remained separate from the accountability attached to delivering that target once agreed.

“There should be absolutely no debate about whether it’s okay or not. It’s absolutely not. It’s a matter of accountability, it’s a matter of democracy, it’s a matter of responsibility,” he said.

Dr. de Mel also called for stronger domestic economic analysis and more responsive forecasting, noting that several assumptions in Government-International Monetary Fund (IMF) projections had diverged from actual outcomes.

“If you fail to plan, you plan to fail. But I think equally, if you’ve planned, when facts change, you must change your mind,” he said.

He said Sri Lanka needed to build greater public sector capacity to analyse its economic trajectory independently and adjust policy as underlying conditions changed.