Of course, I am deeply indebted to His Excellency the President for appointing me as the Governor of the Central Bank of Sri Lanka. I am also indebted to the Hon. Prime Minister and the Hon. Finance Minister for supporting my appointment and I very much hope that I will be able to fulfill the trust they have reposed in me. When I met the President, he just told me one thing, he said “Do your work in a straight way and do not fear anybody in discharging your duties.” Now my intention is to follow his direction. When I met the Honourable Prime Minister, he laid out his vision for where he wants to take this country and there is a big role for the Central Bank. And in many ways, if we are not able to fulfill our functions in the way it should be fulfilled – in-terms of creating a platform for macroeconomic stability with strong macroeconomic fundamentals, having financial sector stability so there is confidence right through the system – nothing else is possible. That is the first step, to get strong macroeconomic fundamentals, to have the financial sector which is the lifeblood of the country stable, and people within the country and outside having confidence in it. So that is our responsibility. And as I said, because I genuinely believe that nothing else will really take off, unless we are able to do our job well, to fulfill our functions well.
Let me briefly outline some of the biases we need to take into account in the context of our economic and financial assessment. For the sake of simplicity, I will distinguish two main categories of biases: technical biases and institutional biases, leaving aside the treatment of risk aversion considerations, which tends to introduce an upward bias in the break-even inflation rate. Technical biases The compound and the convexity biases: the definition of the break-even rate as the difference of the conventional nominal bond yield and the inflation - indexed bond yield is a first order approximation which does not take into account interest rate compounding. Consequently, the break-even rate is an upward biased estimator of expected inflation - provided that inflation expectations are positive4. Interest rate compounding has also another implication as it implies that bond prices will respond in an asymmetric manner to changes in the yield: indeed, bond prices are more sensitive to a fall in yields than to an increase in yield, and therefore, will also rise when the volatility of the yield increases, therefore pushing down the forward rates5. The net convexity adjustment will therefore bias the breakeven inflation rate either upward (the most likely) or downward. The inflation lag: by construction, bond cash flows can not be adjusted instantaneously for actual inflation. This implies that the break-even inflation rate includes another bias reflecting the discrepancy between the lagged and the contemporaneous inflation rate.