Inflation and economic growth

The great economic debate about the relationship between inflation and economic growth was reignited recently when the Central Bank (CB) Governor Dr. Nandalal Weerasinghe remarked that Sri Lanka has to compromise growth if it chooses a lower inflation target. The CB Chief had pointed out that in the event the inflation target is brought down to 2% from next year onwards, interest rates need to be raised unnecessarily – a course of action which he views as detrimental to economic growth. Dr. Weerasinghe had added that having a slightly higher inflation would support growth.

Ironically though, the Governor’s statement is contradicted by Sri Lanka’s own recent economic data. Although the country experienced a 11-month period of deflation that began in September 2024 and extended through most of 2025 before ending in August, the economy grew by 5% last year following the same growth rate in 2024, greatly aided by the lifeline given by the IMF. It is universally acknowledged that inflation erodes real wages and purchasing power, which ultimately dampens domestic consumer demand. Subsequent to the top official’s polarising assertion, a few commentators pointed out that trying to trade off inflation for employment or growth (the traditional Phillips Curve model) is an outdated framework which failed globally in the 1970s.

Persistently high levels of inflation have caused an enormous burden to citizens of the republic, making them poorer and less well-off. Sri Lanka’s annual average inflation rate for 2022 was 49.7%, with year-on-year headline inflation reaching a record high of nearly 70% by September 2022 before gradually coming down. Such high inflation caused a significant deterioration in the purchasing power of consumers apart from pushing a number of families below the poverty line. Given the extraordinary inflationary condition experienced by consumers 4 years ago, even having a slightly high inflation rate could appear painful to the battered islanders.

In the global context too, many countries have been able to achieve high growth rates despite keeping inflation low, and we do not need to go beyond our giant neighbour India – a developing economy similar to us - for verification.  India’s real GDP growth was estimated at 7.4% to 7.6% for FY 2025–26, while its inflation in terms of its consumer price index was measured at 3.5%. It should be noted that the Asian giant’s economic growth has been supplemented by critical supply-side reforms.

Economists have observed that relying on monetary expansion or moderately high inflation to stimulate the economy only treats a symptom rather than curing the disease. For Sri Lanka to achieve sustainable, long-term economic growth, the focus must shift heavily towards structural reforms that drive productivity and investments. Inflationary policies often just inflate nominal GDP without making the country genuinely wealthier. True wealth comes from increasing output per worker, which necessitates substantial enhancement of Sri Lanka’s production capabilities. Encouraging domestic industries (from agriculture to apparel) to adopt automated, digital, and data-driven technologies too is imperative to realise higher levels of productivity. To fuel growth the economy further requires massive inflows of both domestic private investment and Foreign Direct Investment. Transitioning from a lower-middle-income economy to a high-growth, export-driven nation is nearly impossible without giving priority consideration towards Research and Development (R & D). Historically, Sri Lanka’s gross expenditure on R&D has hovered well below 0.2% of the GDP - considerably lower than the 2% to 4% spent by highly innovative economies like South Korea, Israel, or Singapore.

A developing economy such as ours requires sustainable, non-inflationary growth driven by productivity, real capital investment, and global competitiveness. Maintaining low-interest rate regimes as well as providing periodic fiscal stimuluses’ create only short-term economic growth. In the backdrop of differing views as to what the ideal inflation rate for Sri Lanka is, the next statutory review in October on the inflation target would be quite interesting.