Interest rate cut: A calculated easing or a signal of deeper economic concerns?

In a move that surprised many market watchers, the Central Bank of Sri Lanka (CBSL) opted to reduce its Overnight Policy Rate (OPR) by 25 basis points to 7.75% at its May 2025 monetary policy meeting. This decision came against the backdrop of widespread expectations that rates would remain steady, based on relatively benign inflation and improving macroeconomic indicators.

- BY SANATH NANAYAKKARE

According to the CBSL's Monetary Policy Review, the rationale behind the rate cut was rooted in a forward-looking assessment of inflation, growth, and global risks. With inflation projected to turn positive and gradually move toward the 5% target in the third quarter, and core inflation expected to edge upward, the Bank views the current environment as conducive to further monetary easing. The CBSL anticipates that this move will encourage credit growth and support an economy that is showing signs of domestic recovery, albeit within the context of increasing global uncertainty.

Furthermore, CBSL notes that market interest rates have already adjusted downward, and it expects this latest policy easing to translate into even lower lending rates, thus enhancing liquidity and credit expansion which are key ingredients in sustaining economic momentum.

This decision, however, diverged sharply from the pre-policy outlook of First Capital Research, which assigned an 80% probability to policy rates remaining unchanged. They expected the Central Bank to 'hold the line', given that key economic indicators were gradually strengthening. While First Capital did consider a small chance of a 25bps cut (15%), it was seen more as a low-probability measure.

Their analysis also foresaw a largely stable policy environment due to improved liquidity and external sector support, including gains from tourism and remittances. Hence, the actual policy shift suggests that the CBSL is more preemptively cautious or perhaps subtly concerned about lingering fragilities beneath the surface.