UNDERSTANDING FLEXIBLE INFLATION TARGETING AND MONETARY POLICY PROCESS IN SRI LANKA

Inflation, in simple terms, is the sustained increase in general price levels across an economy.

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Such general price levels are usually measured by the price movements of a selected basket of goods and services consumed by an average household. In Sri Lanka, the Department of Census and Statistics (DCS) is the authorised agency that compiles these statistics, which are published monthly. The most widely used measure of inflation is year-on-year inflation, which is measured by comparing today’s general price level with that from the same time a year earlier. Accordingly, if a country records an inflation rate of 5%, it means that, on average, prices of the respective basket of goods and services are 5% higher today than they were a year ago.

If inflation is too high or unpredictable, businesses may struggle to set proper prices, and people may find it hard to plan their spending. Conversely, if inflation remains negative, ie, prices are continuously decreasing, a situation known as a deflationary episode, people may delay purchases in anticipation of lower prices. Prolonged deflation discourages producers, disrupts business activity, and can lead to a slowdown in economic growth.

The Flexible Inflation Targeting Framework

The set of strategies, tools and institutional arrangements that a central bank uses to achieve its monetary policy objective is termed its monetary policy framework. The monetary policy framework adopted by the Central Bank has evolved in response to changes in the domestic and global economic landscape. After following a framework focused on maintaining a fixed exchange rate in the early years after its establishment, the Central Bank adopted a Monetary Targeting framework by the early 1980s. Having undergone a period of gradual transitioning and capacity-building, the Central Bank adopted Flexible Inflation Targeting (FIT) as its monetary policy framework in 2020.