Monetary aggregate targeting frameworks fall between these two extreme regimes depending on the extent of exchange rate flexibility of such policy regimes. Evolution of Monetary Policy Framework in Sri Lanka Sri Lanka’s monetary policy framework has also evolved from a currency board arrangement before the establishment of the Central Bank of Sri Lanka in 1950. This history has been well covered in the masterpiece, “From dependent currency to central banking in Ceylon” written by Professor H A de S Gunasekera, in whose honour my retired senior central bank colleague Sirimevan Colombage delivered an eloquent speech recently at the University of Peradeniya. From 1950 to 1977 Sri Lanka’s monetary policy framework was largely based on maintaining a fixed exchange rate regime in terms of fixing the value of Sri Lanka rupee first to the sterling pound and then to the US dollar. Under this fixed exchange rate regime, domestic inflation was directly linked to foreign inflation and therefore there was no need for an explicit monetary anchor to manage inflation. The Central Bank did not have much leeway to control domestic inflation as the fixed exchange rate was the anchor to manage inflation. Like many other things, inflation was also more or less imported from the United Kingdom those days! This system worked well as long as Sri Lanka earned sufficient foreign exchange to meet expenditure on imports without any restriction.
The government has endorsed this move since then, and stated in its recently released Vision 2025 policy document that “for medium to long-term price stability, the Central Bank will move towards a flexible inflation targeting regime. They will aim at continuously maintaining low inflation while supporting economic activity and competitiveness. The government will implement the legislative and operational changes necessary.” While it is heartening to note that the Central Bank and the government have agreed in principle that flexible inflation targeting is the way forward in the conduct of monetary policy, the full implementation of flexible inflation targeting by the year 2020 will require increased efforts to fulfil the remaining prerequisites for the success of inflation targeting. It is also expected that comprehensive amendments will be made to the MLA to facilitate the transition to flexible inflation targeting, to redefine monetary policy objectives, eliminate monetary financing of fiscal deficits, and ensure Central Bank autonomy and public accountability. Amendments to the MLA are also expected to streamline the monetary policy decision making process. Within the Central Bank, the ongoing upgrade of technical forecasting and analytical capabilities will continue, and it is expected that by 2020, the Central Bank will commence the publication of comprehensive Inflation Reports. The Inflation Report will explain inflation developments, inflation expectations, projections for inflation and other key macroeconomic variables, the assumptions behind such projections, reasons for any deviation of actual inflation developments from targeted levels, and remedial actions to be taken in the case of deviations.