BEYOND DEFLATION

Shiran Fernando deliberates on the outlook for inflation

Sri Lanka has been in deflation territory since September last year with headline inflation – based on the Colombo Consumer Price Index (CCPI) – recording negative 1.7 percent in December and four percent a month later.

Deflation in simple terms is the decline in the price of goods and services compared to 12 months ago. From highs of more than 70 percent in 2022 to negative growth, there’s been a remarkable change in the inflation environment in Sri Lanka from a numbers point of view.

However, this doesn’t necessarily mean that the cost of living has fallen sharply compared to what it was a few years ago; instead, it signals that costs have settled – and even declined marginally relative to growth in absolute terms.

So how did this development transpire? And how is the Central Bank of Sri Lanka responding to it in the light of its mandate and the future outlook for inflation?

THE CENTRAL BANK ACT The main objective of the Central Bank is to maintain domestic price stability. According to the Central Bank Act, it has to maintain quarterly headline inflation of the CCPI at a rate of five percent with a margin of plus or minus two percent.

If the Central Bank fails to maintain headline inflation for two consecutive quarters within this range, the Monetary Policy Board of the Central Bank must submit a report to parliament through the Minister of Finance.

This is stipulated by the Central Bank Act to ensure that the bank, which is accountable to parliament, acts in an independent capacity. For the record, the CCPI stood at 1.4 percent and 0.8 percent during the second and third quarters of 2024 respectively.

REASONS FOR DEFLATION Two key reasons cited by the Central Bank – and are corroborated by the data – are the impact of the appreciation of the Sri Lankan Rupee, and lower energy and transport prices.

The rupee appreciated against the US Dollar by over eight percent in the first nine months of 2024. This resulted in lower costs for imported items ranging from food to fuel. On the supply side, the appreciation of the rupee and moderation in global demand saw global commodity prices easing.

This trend supported the provision of tariff reductions for electricity and water supplies, and decreases in fuel and LP gas prices in 2024. It is also visible in the reduction of electricity tariffs in January.

The Central Bank of Sri Lanka was expecting the decline in utility prices to be negated by the increase in VAT during the year. But this didn’t materialise, possibly due to weak aggregate demand since consumers are still recovering from the double shocks of the pandemic and economic crisis.

CORE INFLATION DATA Quarterly average core inflation is based on headline inflation but excludes volatile food and energy items in the CCPI basket. Therefore, it’s more reflective of the underlying demand conditions in the country.

During the two quarters mentioned earlier, core inflation was 3.8 percent higher than headline inflation. And by the end of 2024, core inflation stood at 2.7 percent, which is higher than the 1.7 percent contraction of headline inflation. This divergent view highlights the reversal of supply side shocks in 2024 relative to 2022.

CENTRAL BANK STANCE In response to inflation cooling and economic activity slowing down in 2023, the Central Bank of Sri Lanka has been reducing interest rates since June 2023.

This move is to address slowing demand conditions rather than a strategy to curb supply side shocks. These supply side shocks tend to have an immediate impact while monetary policy effectiveness takes time and may not address short-term price volatility.

The Central Bank reduced interest rates by another 0.5 percent in its November 2024 monetary poli­cy review. This should stimulate borrowing by the private sector and lead to a pick up in demand so that the deflationary cycle is reversed.

MID-2025 TARGET The Central Bank expects deflation to continue into the first quarter of this year and be followed by inflation from the second quarter onwards. And it only expects inflation to be around the five percent target threshold by the third quarter

In the meantime, the electricity tariff reduction in January may prolong the period of deflation for a few more months.

There are other risks as well in achieving the inflation target in 2025 – such as currency movements. In January, the rupee’s spot rate against the dollar fell. At the time of writing, the greenback was at its highest level in over two years, following the election of President Donald Trump.

With the reopening of imports of personal vehicles, we will see further pressure on the currency with the issuance of letters of credit. Furthermore, when the external debt restructuring process is concluded, Sri Lanka will need to begin paying interest on its rescheduled loans, and this could add pressure on inflation as well.