The government's elation early this month over the slight decline in the inflation rate according to analysts would be short lived as subsequent actions by the Central Bank have now compromised a further decline in the rate.

The country's inflation rate declined for the first time this year to 26.6% in July from a record high of 28.2% in June as per the new index, the CCPI(N) which was custom designed to show lower inflation.

Although the government announced the decline in the inflation rate from 28.2% to 26.6%, it still remains the highest inflation rate in the region.

The lack of monetary reforms that could stimulate the economy has caused doubts on sustaining a continued downward movement of the inflation index, which according to analysts should be a primary objective of the government, especially the Central Bank.

Financing the budget deficit

Recent actions of the Central Bank have intensified calls by analysts to abolish the institution and form a currency board that could block the Central Bank from financing the government.

The bank has in the past few years played a key role in financing the government's budget deficit, which in turn has driven inflation over the roof. The Central Bank is now engaged in yet another act that analysts warn, would in turn have an adverse impact on the high inflation rate.

The bank in its Monetary Policy Review for August said, in terms of the bank's policy of restraining  investment in new Treasury Bills, it had exhausted its stock of Treasury Bills available for open market operations.

"Hence, the bank has moved to issuing its own securities to mop up the excess liquidity and contain reserve money growth to the target level. The Central Bank's tight monetary policy stance has enabled it to successfully maintain its operational target, namely, reserve money, within the targeted path during the first half of the year as well as thus far during the third quarter," the Central Bank stated.

It was reported last week that on Tuesday (19) the bank had sold Rs. 4.8 billion of its own securities at a rate of 11.82%.

High monetary expansion

The bank further said that this, in turn, had checked the high monetary expansion, which has been on a decelerating trend since early 2008.

Accordingly, the broad money growth decelerated from 16.6% at end 2007 to 13.6% by end June. Credit to the private sector, which was on a higher than desired growth path and remained a concern of the Central Bank, also decelerated to 12.7% by end June, from the higher growth rates ranging from 20 - 26% in 2007.

As such, the tighter monetary policy stance has yielded its desired impact on monetary aggregates, decelerating the expansion in aggregate demand.

"The favourable impact of this deceleration in aggregate demand coupled with the healthy developments on the supply side are expected to be observed during the forthcoming months in the form of moderating inflationary pressures in the economy," the bank also said.

The country's inflation rate has been on the increase since last year mainly due to the loose monetary policy followed by the Central Bank. However, the Central Bank tightened its monetary policy this year and has stated that the inflation rate should moderate towards the latter part of the year.

Driving inflation sky high

It has been reported on many occasions on how the Central Bank acquired a large stock of Treasury Bills in 2007 in the course of printing money to finance the country's budget deficit driving the inflation rate sky high and causing a balance of payments crisis.

Although the bank managed to sell most of the Treasury Bills in the first quarter, it again started to buy bills to pump in money into the banking system during April.

The Central Bank has said it will keep reserve money growth down to 11.75% in 2008, which is tighter than the initially planned 12.5%.

Reports have also indicated the downside of the Central Bank's decision to maintain a peg with the US dollar at Rs. 108.70.

Economic analysts have reportedly said that if a peg is maintained, the peg automatically determines the reserve money requirement of a country when net balance of payments proceeds are converted to rupees.

Accordingly, if money is generated in excess of the peg, by the acquisition of Treasury Bills by the Central Bank, it causes a balance of payment crisis and high inflation.

Economists have repeatedly called for longer-term monetary reform to change the laws governing the Central Bank to allow it to conduct better monetary policy primarily aimed at keeping inflation low.

However, in its August monetary policy statement the Central Bank said inflation would continue to move down.

Difficult to rein-in inflation

Analysts have been rather pessimistic and say that although the Central Bank has so far tightened monetary policies, it has found it difficult to rein-in inflation as the policy interest rate has been kept far below inflation at 12%.

In fact, Professor of Applied Economics at the John Hopkins University, Baltimore and a Senior Fellow at the Cato Institute, Steve H. Hanke earlier in the year stated that the spectre of unanchored inflation haunts the Sri Lankan economy.

Those expectations, according to Hanke have thrown into doubt the Central Bank's 2008 inflation target of 10% to 11%.

"To slay the inflation bogey, Sri Lanka needs new institutions that will deliver discipline," he stated.

He explains that at the end of the day, inflation is always a monetary phenomenon. This is, of course, the case in Sri Lanka. The problem resides at the Central Bank. It doesn't have a credible anchor. In consequence, it lacks the discipline to control inflation and contain inflation expectations.

According to analysts, mostly the lack of discipline of the Central Bank and the printing of large sums of money to fund unproductive expenditure by the government have been the root causes of the high inflation rate.

Meanwhile, a recent analysis by top-level economists attached to HSBC had revealed that inflation in Sri Lanka was largely a fiscally caused monetary phenomenon, because the large fiscal requirements of the government were met by the Central Bank printing money.

The Central Bank has continuously denied its role in fuelling inflation by pumping too much money into the market.