Monetary Policy

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 - 2010 >>

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 signalling 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
Deputy Governor responsible for Financial Stability
Assistant Governor responsible for Price Stability
Assistant Governor responsible for Financial Stability
 Director of Economic Research
Additional Director of Economic Research responsible for
Money and Banking
(Alternate, Deputy Director, Economic Research responsible for
 
Money and Banking)
Director, International Operations (Alternate, Deputy Director,
International Operations)
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 InformationAppointment of the Monetary Policy Consultative

Committee
As per the "Road Map for Monetary and Financial Sector Policies for 2007 and
Beyond" announced on 2 January 2007, a Monetary Policy Consultative
Committee has been set up by the Central Bank of Sri Lanka. The seven member commiittee
consists of a cross section of stakeholders and academics so that the Bank could benefit by
their expertise and experience in its monetary policy decision making process.

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.