2% or 5% inflation is not the question

The call for cutting the inflation target from 5% to 2% is gaining momentum. The case rests on an appealing proposition: less inflation means more monetary stability, lower interest rates and fewer distortions. But the argument risks confusing a lower numerical target with better monetary policy.

Sri Lanka’s problem has not been whether inflation was targeted at 2% or 5%. We have seen repeated failures to maintain monetary and fiscal stability in the past. But the dynamic has changed with new laws governing public finance and the Central Bank.

The claim that a higher inflation target increases the risk of overshooting does not necessarily follow. A Central Bank capable of holding inflation around 2% should also be capable of holding it around 5%. Conversely, weak policy, fiscal dominance or an external shock can overwhelm either target. Moving the number down does not remove those risks.

Nor does a 5% target amount to a policy of artificially cheap money. Interest rates can remain consistent with a 5% inflation target without being suppressed below market-clearing levels. The danger comes when monetary policy holds real rates too low for prevailing economic conditions, not from the inflation target itself.

The historical comparison with the past also warrants caution. Low inflation and interest rates then existed under an economic structure, exchange-rate regime, capital account and global monetary system far removed from those confronting Sri Lanka today. Singapore provides another useful lesson in monetary discipline, but its economic structure, external balance and monetary framework are hardly replicas available for Sri Lanka to adopt.

More importantly, inflation targeting involves trade-offs.

Sri Lanka remains exposed to oil, food and other imported price shocks. A 2% target could require a tighter adjustment path following persistent supply-driven inflation. Trying to force inflation rapidly back to 2% after an external shock could require interest rates and credit conditions that impose costs on investment, employment, public finances and an economy still rebuilding its capital stock.

That does not make inflation desirable. It means the cure carries costs too.

The proposition that exchange-rate depreciation merely magnifies imported shocks also understates the role of the exchange rate in adjustment. A country cannot simultaneously expect its exchange rate to remain stable, monetary policy to pursue an inflation target and capital to move freely without confronting the constraints imposed by the monetary policy trilemma. Something must adjust.

The strongest objection, however, is to the claim that a higher inflation target will lead to balance-of-payments crises. Sri Lanka’s external crises have involved fiscal deficits, monetary financing, reserve depletion, exchange-rate management, external borrowing and structural weaknesses. To assign such crises principally to whether the inflation target is 5% rather than 2% gives one policy parameter explanatory power it does not possess.

Credibility also does not require eliminating discretion. Central banks confront wars, pandemics, commodity shocks, financial crises and other events that no rule can fully anticipate. Credibility comes from explaining decisions, acting consistently with a mandate and returning inflation to target over a credible horizon, not from refusing to respond when circumstances change.

We certainly need monetary discipline. We need price stability, an independent Central Bank, continued fiscal discipline and structural reform. The institutional framework has also changed, with much tighter constraints on monetary financing of Government deficits.

But none of those propositions establishes that 2% is the right inflation target.

After the economic dislocation we have endured, the burden of proof lies with those proposing another change to the monetary framework. The question is not whether 2% inflation sounds better than 5%.

It is whether the economy is sufficiently resilient to adjust to those trade-offs, and whether forcing inflation towards 2% would deliver benefits greater than the economic costs required to get there and keep it there.

International experience offers successful examples across very different monetary regimes, from independent central banks to currency boards. The framework matters more than the number.