"The idea is simply that many central banks around the world have found that targeting the money supply is not always the best way to achieve inflation objectives since the relationship between the intermediate target (the money supply) and the ultimate target (inflation) has become increasingly unpredictable. The Central Bank of Sri Lanka has long recognized this and spoken of a desire to move eventually toward a regime that more directly targets inflation, because this is what everybody is interested in at the end of the day," Dr. Mathai told The Island Financial Review.
Since peaking at 28.2 percent in June 2008, inflation has subsided reaching the lowest of 0.7 percent in September 2009. Inflation, the point-to-point change in the Colombo Consumers’ Price Index, was 5 percent in August 2010.
"International experience suggests a number of preconditions for introducing inflation targeting. Among other things, it has proven difficult for countries to introduce inflation targeting when inflation is still running very high, or when exchange rates are inflexible. With inflation in Sri Lanka now reasonably low and the rupee increasingly flexible, we think the CBSL is in a good position to think of reforming its monetary policy framework. We have worked together with the CBSL on some of the technical modelling framework required for such an inflation targeting regime," he said.
According to economists, when targeting inflation directly, instead of using policy rates to target money supply, the Central Bank would have to abandon excessive intervention in the foreign exchange market which keeps the exchange rate at an unrealistic position and also refrain from intervening in the primary Treasury bill markets.
Maintaining artificially stable exchange rates, inflation and interest rates is referred to economists as the impossible trinity.
In 1990, New Zealand was the first country to abandon its monetary targeting framework for an inflation targeting one, and has experience low inflation and high growth except for brief periods in 1995 and 2000.
Canada followed New Zealand in 1991, and brought down inflation from 5 percent in 1991 to 2.5 percent in 2006.
Australia, Brazil, Chile, Iceland, Israel, South Korea, Mexico, Norway, Philippines, Poland, South Africa and Turkey are some of the other countries directly targeting inflation.
In inflation targeting, authorities announce a band in which inflation is maintained.
Credit growth slow...
With inflation and interest rates at low levels, the banking sector could spark off inflation if credit for consumption grows too fast, but Dr. Mathai said it was certainly not a cause for concern right now.
"We see no signs of demand-driven inflation right now and our primary worry is not that an overly fast expansion of credit could fuel inflation, but we are more concerned that credit has been relatively slow to pick up, as it is the lifeblood of the economy and will be needed to support growth.
"Even there, however, we need to recognize that GDP growth has already accelerated quite nicely, and we are certainly not urging the banks to extend credit willy-nilly. But we do need a more careful diagnosis of why leading corporates may still be cautious in demanding credit. One reason may be that many of them are cash-rich, having had a strong recent quarter, and can rely on internal funds, but I don’t think we have a complete answer," Dr. Mathai said.
source - www.island.lk
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