Monetary policy review - January 2011

Inflation, as measured by the year-on-year change in the Colombo Consumers' Price Index (base=2002) was 6.9 percent in December 2010.

Annual average inflation in 2010 was 5.9 percent. Accordingly, inflation has continued to hover around mid-single digit levels, although weather related factors and supply disruptions have led to increases in prices of some selected food items time to time.

However, these price increases in the domestic economy are expected to have only a transient effect on domestic inflation, and current monetary developments do not indicate any significant demand pressures in the economy emanating from second round effects of these price increases.

The continued stability of the Sri Lanka rupee has also cushioned price increases of imported commodities, while measures taken by the government, particularly downward adjustments to tariffs applicable to imported commodities, helped reduce price pressures further.

In the coming months, domestic agricultural production is expected to increase along with the increase in the extent of land cultivated.

In addition, the enhanced capacity utilisation in many sectors of the economy, with the development of infrastructure, reasonable productivity gains and greater efficiency of capital employed, would help ease domestic price pressures.

By November 2010, year-on-year growth in credit granted to the private sector by commercial banks was 23 percent, partly due to the base effect, given that a negative growth of around six percent was recorded for November 2009.

During the same time frame, growth in broad money supply in 2010 recorded an average value of around 15 percent, thus remaining consistent with the target stipulated in the monetary program for 2010.

Data relating to developments on the fiscal front indicate that the deficit in the national budget would be well within the targeted eight percent of GDP in 2010.

Meanwhile, the government remains committed to securing a budget deficit of 6.8 percent of GDP in 2011 with current indications showing that such deficit target is very likely to be achieved.

This favourable macroeconomic environment provides the required space and comfort for new and wider investments to be made in all sectors of the economy, including new growth areas, without fuelling undue inflationary pressures in the period ahead, firmly supporting the country's growth potential. In that scenario, the encouragement of substantial and sustained private sector participation in economic activity in the years ahead, would be vital.

A reasonable relaxation of the Central Bank's monetary policy stance therefore would be timely.

Such policy stance would result in a further reduction in market interest rates, which would reflect the lower risk premia that is expected to prevail in the period ahead, without increasing the inflationary pressures in the economy.

Taking into consideration, inter alia, the key factors discussed above, the Monetary Board, at its meeting held on January 10, decided to reduce the Central Bank's Repurchase rate by 25 basis points and the Reverse Repurchase rate by 50 basis points to 7.00 percent and 8.50 percent, with effect from January 11.