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MONETARY POLICY: ‘5% target gave CBSL room to maneuver’

The Central Bank of Sri Lanka's inflation target of 5% allowed it the flexibility to only increase interest rates by 1% or 100 bps in May – and forego further tightening, Director of Economic Research Lasitha Pathberiya said, speaking on the CBSL's panel discussion on inflation target review on Friday (9).

Speaking of a hypothetical 2% inflation target, Pathberiya said: "If we had the inflation target of 2% at that time, then our response would have been much, much higher than 1% increase."

In May 2026, the CBSL's Monetary Policy Board decided to increase the Overnight Policy Rate (OPR) by 100 bps to 8.75% – the most significant rate increase since March 2023.

"So we increased our interest rates by 1%. But if we had the inflation target of 2% at that time, then our response would have been much, much higher than 1% increase. So that's the cost to the economy."

Pathberiya said that since the CBSL had a 5% target, it was able to flexibly navigate the subsequent supply shock that was brought on with the sharp increase in oil prices, felt due to the geopolitical tensions.

"So because we had a 5% target we could look through this supply shock to a certain extent and we still increased to a certain 1% increase in interest rates."

In April, the CBSL noted that high global oil prices necessitated sharp upward adjustments to domestic energy prices, largely contributing to the 5.4% (y-o-y) inflation in April 2026.

However with inflation at 8.0% reported in September, 3 percentage points higher than the 5% target, the CBSL held rates unchanged at 8.75%. It characterised the inflation as "supply-driven" and projected that it would "ease" towards the 5% target in 2027.

The Board noted that it stood ready to take timely and appropriate measures in the case of inflationary pressures intensifying and signs of expectations de-anchoring.

CBSL Senior Economist Vishuddhi Jayawickrema said that among emerging and developing economies around the world, the cost of bringing down inflation typically falls between 0.5 and 2–3 percentage points, depending on circumstances. She called this trade-off a sacrifice ratio.

"Typically in research studies around the world, if you take developing or emerging market economies, the sacrifice ratio is around half a percentage point to around two to three percentage points, depending on the economic circumstances."

"That means if you try to reduce inflation by 1% by tightening monetary policy, your output may contract from 0.5 to 2–3 percentage points. There were cases of even higher sacrifice ratios as well. This is very well established, it's an empirically established fact that there will be loss in output and employment if you try to reduce inflation through policy actions."

Under the new Monetary Policy Framework Agreement (MPFA) introduced this month, the CBSL and Sri Lankan government officially renewed the headline inflation target at 5%, with an allowed accountability band of ±2 percentage points (permitting a fluctuation range between 3% and 7%).