Monetary Policy Regular page >>
Economic and Price Stability
Economic and price stability is a situation where there are no wide fluctuations in the general price level in an economy which helps to achieve sustainable economic growth. When the prices fluctuate at a low rate, they would not have any significant influence on economic decisions of participants of an economy, viz. households and firms. Therefore, stable prices would not distort the economic decisions regarding what to produce and how to produce, thus enabling efficient allocation of resources in the economy leading to economic stability.

Price Stability - Pamphlet Series No.1 >>


Monetary Aggregates
The changes in money supply are a primary causal factor affecting price stability. In general, three definitions of monetary aggregates are used in analysing monetary developments in Sri Lanka. The first is 'reserve money' consisting of currency issued by the Central Bank and commercial banks' deposits with the Central Bank. This is also called base money or high-powered money, as commercial banks can create deposits based on reserve money which are components of a broader definition of money supply, through their process of creating credits and deposits. The second is narrow money , defined as the sum of currency held by the public and demand deposits held by the public with commercial banks. The third is broad money defined as the sum of currency held by the public and all deposits held by the public with commercial banks. Studies have shown that the most appropriate monetary variable to analyse the relationship between the money supply and the general price level is the broad money supply.

Monetary Policy Framework
At present, monetary management in Sri Lanka is based on a monetary targeting framework. In this framework, the final target, price stability, is to be achieved by influencing changes in broad money supply which is linked to reserve money through a multiplier. Reserve money is the operating target of monetary policy . The monetary targeting framework is operated through a monetary programme.

The monetary programme is prepared by the Central Bank taking into account economic factors such as the expected fiscal and balance of payments developments, economic growth, desired levels of growth in credit and inflation. Based on these factors, the monetary programme sets out the desired path for monetary growth and determines the path of quarterly reserve money targets necessary to achieve this monetary growth. The Bank would then conduct its Open Market Operations (OMO) within a corridor of interest rates formed by its policy rates i.e. the repurchase rate and the reverse repurchase rate, to achieve the reserve money target. Policy rates are periodically reviewed and adjusted appropriately, if necessary, to bring the reserve money to the targeted path.

Monetary Programme - 2007 >>

Monetary Policy Instruments and Implementation
The Central Bank possesses a wide range of tools to be used as instruments of monetary policy. The main monetary policy instruments currently used are (a) policy interest rates and open market operations (OMO), and (b) the statutory reserve requirement (SRR) on commercial bank deposit liabilities.

( a ) Policy Interest Rates and Open Market Operations (OMO)

  • At present, the Central Bank conducts its monetary policy under a system of active Open Market Operations. The key elements of the system are (i) an interest rate corridor formed by the main policy rates of the Bank i.e. the repurchase rate and the reverse repurchase rate, (ii) a daily auction either to absorb or inject liquidity, (iii) a standing facility at interest rates at the bounds of the corridor and (iv) outright transactions.

  • The main instruments to achieve the path of the reserve money targets are the repurchase rate and the reverse repurchase rate of the Central Bank which form the lower and upper bounds for the comparable overnight interest rates in money markets. These rates, which are the Bank's signaling mechanism on its monetary policy stance, are reviewed on a regular basis, usually once a month, and revised if necessary.
  • A daily auction is conducted either to absorb liquidity through repurchase transactions, if there is excess liquidity, or to inject liquidity through reverse repurchase transactions, if there is a shortage of liquidity and thereby to maintain overnight interest rates stable around a level considered consistent with the path of reserve money targets. The auction is on a multiple bid, multiple price system. Participants could make up to three bids at each auction and the successful bidders would receive their requests at the rates quoted in the relevant bid.
  • Standing facilities are available for those participating institutions which were unable to obtain their liquidity requirements at the daily auction. That is, even after the daily auction, if a participant has excess money he could enter into a repurchase transaction under the standing facility. Similarly, if a participant needs liquidity to cover a shortage, he could borrow funds on reverse repurchase basis under the standing facility. Accordingly, these facilities help containing wide fluctuations in interest rates.
  • Outright transactions are conducted at the discretion of the Central Bank to address long term liquidity issues. If a relatively large liquidity surplus exists and is likely to persist for a long period it is absorbed by selling Treasury bills outright out of the holdings of the Central Bank, and if a sufficient stock of Treasury bills is not available, by issuing the Central Bank's own securities. Similarly, a long term liquidity shortage would be removed by purchasing Treasury bills and bonds in the secondary market and buying Treasury bills in the primary market.
  • There also exists another policy rate known as the Bank Rate. It is the rate at which the Central Bank provides credit to commercial banks as a lender of last resort. These are collateralised loans and government securities are accepted as collaterals. The Bank rate is usually a penalty rate and it is higher than other market rates. Therefore, at present this rate is just an indicative rate as commercial banks can borrow from the Central Bank at the reverse repurchase rate which is less than the Bank rate.

( b ) Statutory Reserve Requirement (SRR)
  • The statutory reserve ratio (SRR), i.e., the proportion of the deposit liabilities that commercial banks are required to keep as a cash deposit with the Central Bank, also has been widely used to influence money supply in the past. However, the reliance on SRR as a day to day monetary management measure has been gradually reduced with a view to enhancing market orientation of monetary policy and also reducing the implicit cost of funds which the SRR would entail on commercial banks.
  • Under the MLA, commercial banks are required to maintain reserves with the Central Bank at rates determined by the Bank. At present, demand, time and savings deposits of commercial banks denominated in rupee terms are subject to the SRR and the applicable ratio is 10 per cent on all deposit liabilities.

Monetary Policy Committee (MPC)
A primary function of the Central Bank, as stated in the Monetary Law Act, is the determination and implementation of monetary policy for the country. Over the years, the economy, and in particular the financial sector has deepened and become more sophisticated. Consequently, the Bank's tasks in determining and implementing monetary policy have also increased in complexity. Hence, as a part of the Bank's ongoing process of adapting itself to meet new challenges, and as a step towards improving the transparency of the decision making process, a formal monetary policy committee (MPC) was established in early 2001, to study and make recommendations on monetary policy for the consideration of the Monetary Board.

The Monetary Policy Committee (MPC) is chaired by the Deputy Governor in charge of Price Stability and includes the following members:
Chairperson
  Deputy Governor responsible for Price Stability

Members
1 ) Deputy Governor responsible for Financial Stability
2 ) Assistant Governor responsible for Price Stability
3 ) Assistant Governor responsible for Financial Stability
4 ) Director of Economic Research
5 ) Additional Director of Economic Research responsible for Money and Banking
(Alternate, Deputy Director, Economic Research responsible for Money and Banking)
6 ) Director, International Operations (Alternate, Deputy Director, International Operations)
7 ) Director, Domestic Operations (Alternate, Deputy Director, Domestic Operations)

Secretary to the MPC
 The Deputy Director, Economic Research responsible for Money and Banking (Alternate, Head of Division, Money and Banking).

The primary function of the MPC would be to forecast and evaluate emerging monetary and macro-economic developments and make recommendations on appropriate future directions of monetary policy for consideration by the Governor and the Monetary Board.

The MPC would meet at regular intervals, at least once a month. At these meetings, members would consider reports prepared by the Economic Research Department and other departments on monetary, foreign exchange market and price developments, together with developments in the fiscal, external and real sectors, which would serve as the bases for the deliberations of the MPC, in the formulation of recommendations to the Governor and the Monetary Board.

Dissemination of Information
 Changes in monetary policy, including information on the rationale for such changes, are notified to the public, including all market participants, through press releases, press statements made by senior officials of the Central Bank and posting on the Bank's website. The Central Bank's website is updated whenever necessary. Usually, press conferences are held by senior Central Bank officials if the changes are significant. In addition, senior officials of the Central Bank are frequently interviewed by the media.

The Communications Department of the Central Bank, which is responsible for disseminating information to the public, handles matters relating to press releases and press briefings. Information is disseminated by way of monthly bulletins, news surveys, press releases, the Annual Report, and other publications.

When substantive changes to the policy are proposed, consultations would usually be held with organisations affected by the proposed changes e.g., Bankers' Association, Primary Dealers' Association. Monthly meetings are held by the Governor with chief executive officers of commercial banks and licensed specialised banks, at which the monetary situation and likely monetary policy measures are discussed. Meetings with primary dealers are held by senior officials of the Central Bank once a week.

An advance release calendar of monthly monetary policy announcements is published in the Central Bank's website at the beginning of each year and monthly announcements on the monetary policy stance are made on these dates.

Monetary Policy Advance Release Calendar>>