“…Director at the Economic Research Department of the Central Bank said that headline inflation is expected to be positive from the start of Q3 and move towards the targeted range by the end of the year. The Central Bank Governor told COPF that it is a challenge to maintain inflation at the targeted level when there is too much volatility in a major component of the overall index.”
– Quoted from the Press
Why inflation matters
People experienced the ruinous effects of inflation during the recent crisis, so the threat of its resurgence should be taken seriously. Inflation erodes income and savings; redistributes wealth, and distorts investment and resource allocation. Its most destructive effects are on savings. Although it affects everyone, this impact is most acute for retirees for whom the real value of accumulated savings is a lifeline.
Savings are crucial for the elderly to ensure a comfortable and secure retirement. They provide financial stability, allowing seniors to manage healthcare costs. Savings are of particular concern in Sri Lanka because of its rapidly ageing population — by 2042, almost one in four people is expected to be elderly.
The importance of savings
One of the important functions of money is as a store of value. The majority of people hold their savings in the form of money. Physical assets such as land or gold will retain their value regardless of fluctuations in the value of money but only a minority are able to invest in these (apart from their own house).
While Sri Lanka’s overall health indicators are good, facilities for elderly are woeful. The quality of care for diseases of longevity: dementia, heart disease, diabetes is poor. The breakdown of the extended family and large-scale migration of the young means the traditional system of support is in decline. Care homes become increasingly important but what facilities exist are mostly privately provided, inadequate, and expensive. The early retirement age and age discrimination in hiring limit employment opportunities and deepen the economic challenges for older workers.
Thus on retirement, the average citizen who does not enjoy the benefit of a state pension must try to live on whatever savings they have accumulated.
Higher medical costs are inevitable with age and increase progressively with time due to the risk of developing chronic conditions; heart disease, diabetes etc which require ongoing treatment. The financial burden becomes critical if emergency treatments arise due to medical complications.
The challenge for retirees is to balance the lack of income generating opportunities with rising costs. Preserving the value of their savings is vital. People who enter retirement can expect to live for another 20-30 years. Planning over such a long horizon, very difficult at the best of times, becomes almost impossible under high inflation.
The effect of inflation on savings
In 2023 the CBSL adopted a target of 5% for inflation (with a 2% margin) thus inflation could reach 7%. Many countries use a target between 1% to 3%, with 2% being common. Considered in the abstract and in isolation from the realities of life the difference between 2%, 5%, or 7% seem small but the impact that this has on people’s savings is far from insignificant.
Assume that people just entering retirement expect to live another 20-30 years and have savings of Rs10,000,000. The table below illustrates the approximate impact of inflation. If inflation reaches 7% by age 75 a retiree would have lost 74.16% of their savings’ value. If inflation were 2%, the loss would be 32.7%. The dramatic loss in value occurs because each year’s price increases build upon those of previous years, causing it to compound over time. Even a seemingly small difference in the annual inflation rate can accumulate alarmingly over decades, severely reducing the true value of retirement savings.
Sri Lanka’s inflation history
How has Sri Lanka fared in the past? One way to illustrate this is by looking at the rupee’s exchange rate against the US dollar. While not exact, the compounded effect of inflation is broadly reflected in the currency’s depreciation.
Over this entire forty five year period, the annual average annual depreciation has been around 6.7%, within the upper range of the new inflation target. In effect, the new framework risks entrenching the same instability that led to repeated crises, rather than breaking from it.
The impact on savings of the elderly is stark but the youth are not much better off. Even apparently modest levels of inflation can quietly erode the everyday well-being of citizens. As prices rise, people find that their salaries buy less, forcing difficult choices and limiting lifestyles. It also becomes harder to save, and what savings are possible lose value. The exchange rate weakens, making imports more expensive and feeding a cycle of rising costs. For those on fixed or low incomes, these pressures are especially severe.
Setting an inflation target
It is clear that the lower the rate of inflation the better. A rate close to zero minimises the economic costs resulting from price distortions so why not settle for that? The problem is that central banks throughout the developed world have been overwhelmed by the fear of deflation.
Why is deflation feared?
The CBSL ran deflationary policy between 2022 to 2024, selling down its stock of treasury bills, and inflation fell close to zero. The exchange rate strengthened (from Rs360 to Rs300) bringing down the costs of imports, particularly energy.
Declining prices are not necessarily a bad thing. Increased productivity; a higher level output for a given level of inputs will result in falling prices. Sri Lanka’s productivity levels, never high, have declined in the recent past. The government should encourage falling prices not through price controls but by supporting productivity improvements. It should dismantle barriers to productivity growth; for example by easing restrictions on trade and investment.
Falling prices mean improved living standards so why do central banks fear this? The problem is that Keynes, writing in the aftermath of the Great Depression, succeeded in associating deflation with unemployment, a fear that remains today. Attempting to avoid deflation at all costs leads to an inflationary bias in policymaking. Stephen D. King notes:
“Throughout history, the price level has both risen and fallen. During the twentieth century and beyond, price level declines have become rarities. Indeed, as the twentieth century rolled into the twenty-first, the fear of price declines turned into something of a fetish. The possibility of ‘good deflation’, of the kind witnessed in the late nineteenth century, was ignored. Instead, all forms of deflation were regarded as economic developments best avoided.
If wages were ‘sticky’ and could not easily fall, then price declines would simply lead to collapsing profits and mass bankruptcies, threatening to deliver the mass unemployment seen in the 1930s.
In 2023, the CBSL adopted a target of 5% for inflation (with a 2% margin), thus inflation could reach 7%.
….Inevitably, however, an approach that attempts to avoid deflation at all costs is likely to end up delivering an inflationary bias. Importantly, this bias will probably be in place even during periods when, arguably, ‘good deflation’ would have been perfectly acceptable”.
When inflation is measured using price indices, declining prices register as “deflation”, regardless of their cause.
Rethinking inflation and monetary policy
Inflation should not be viewed in terms of abstract statistics but in terms of the impact it has on economic activity. Former Federal Reserve Chairman Paul Volcker endorsed Greenspan’s definition of the right level of inflation as:
“That state in which expected changes in the general price level do not effectively alter business or household decisions.”.
In other words, one low enough that people don’t need to think about it in their daily lives.
He also noted that inflation indices are inherently imprecise and that obsession with hitting exact numerical targets leads to poor policy decisions.
“No price index can capture, down to a tenth or a quarter of a percent, the real change in consumer prices. The variety of goods and services, the shifts in demand, the subtle changes in pricing and quality are too complex to calculate precisely from month to month or year to year. Moreover, as an economy grows or slows, there is a tendency for prices to change a little more up in periods of economic expansion, maybe a little down as the economy slows or recedes, but not sideways year after year.” (Volcker, 2018)
Volcker gets to the essence of monetary policy: to preserve trust in the currency’s future value.
“we take for granted, or should, the stability of our currency in terms of what it can buy today, tomorrow, and for years ahead—groceries, a home, or maybe even a bond that promises to pay a fixed amount of dollars into the future. Maintaining that expectation, that confidence, is a fundamental responsibility of monetary policy.”
Viewed this way, a 2% target is better than 5% but as Volcker points out.
“2% inflation rate, successfully maintained, would mean the price level doubles in little more than a generation”.
He also warned that translating this concept into a fixed numerical target—especially one with an implicit floor creates an inflationary bias:
“such seeming numerical precision suggests it is possible to fine-tune policy with more flexible targeting as conditions change. Perhaps an increase to 3% to provide a slight stimulus if the economy seems too sluggish? And, if 3% isn’t enough, why not 4% ?” (Volcker, 2018)
Understanding depressions
The prolonged unemployment of the Great Depression was an unusual situation associated with the bursting of a financial bubble. The Great Depression of the 1930’s was preceded by the “Roaring Twenties” when cheap credit provided by the Federal Reserve underlay an unsustainable economic expansion that lasted through mid-1929.
“artificial low interest rates misguide entrepreneurs. The excessive credit growth through low interest rates distorts entrepreneurs’ profit and-loss calculations, in that they calculate a high investment return; the banks’ perception of credit risk corre spondingly decreases. Malinvestment rises as unfeasible projects are misevaluated as being feasible because of the strong demand fostered by artificially cheap credit” observes Aykut Ekinci in his 2016 paper Rethinking Credit Risk under the Malinvestment Concept: The Case of Germany, Spain and Italy.
When a boom driven by cheap credit ends, businesses discover that they have made investments for which there is no demand. Distorted during the boom, the mix of goods is unsustainable and so too is the level of production. Unwinding the excess is slow because of the specificity of investments. At least some goods will be durable as well as being firm or even project-specific. Liquidation of such goods and the firms or projects employing them, will be a difficult and time-consuming process. If particularly widespread, it could threaten the banking sector.
Thus the period of adjustment after an inflation fueled boom is long and painful, creating the prolonged unemployment witnessed by Keynes. The longer the boom, the worse the problem. The solution is not to fear the depression but to avoid the cheap money policies that inflate unsustainable bubbles.
John Taylor supports this view, arguing that over expansionary policy, in the United States and the Euro area, was responsible for accelerating the housing boom and thereby ultimately leading to the 2008 housing bust, a view echoed by Danthine who states a long period of low interest rates may encourage financial intermediaries to take increased risks with negative consequences for systemic stability (Danthine, 2012). Taylor suggests that, if central banks had set higher interest rates in this period, the subsequent housing bubble and the \ global financial crisis might have been avoided.
Volcker concurs, arguing that the only threat from a deflation is if there is a breakdown of the financial system which means avoiding cheap money policies.
“Deflation is a threat posed by a critical breakdown of the financial system. Slow growth and recurrent recessions without systemic financial disturbances, even the big recessions of 1975 and 1982, have not posed such a risk.
The real danger comes from encouraging or inadvertently tolerating rising inflation and its close cousin of extreme speculation and risk taking, in effect standing by while bubbles and excesses threaten financial markets. Ironically, the “easy money,” striving for a “little inflation” as a means of forestalling deflation, could, in the end, be what brings it about” writes Volcker.
Monetary policy objectives for Less Developed Countries
The objectives of monetary policy should be to maintain internal stability (price stability or inflation) and external stability (avoiding balance of payments (BoP) crises). A BoP crisis is a foreign exchange crisis; a breakdown in a country’s ability to access or retain international money, hence a monetary phenomenon.
Countries that do not issue a reserve currency must be able to acquire and indeed accumulate, the currency they cannot issue to pay for imports, service external debt and build reserves. As a result, domestic policy is shaped and constrained to a significant degree by external performance. In this sense the country is balance–of–payments constrained. The external performance constrains the domestic policy space, including that of fiscal and monetary policy.
Because foreign inflows are difficult to control or even predict, reserve accumulation requires managing outflows. The clear lesson of the last crisis (as well as those of the 1960-70’s) is that quantitative restrictions and tariffs are ineffective. The only effective mechanism to regulate foreign outflows is the interest rate which determines overall levels of consumption and investment. If reserves are to be accumulated, the interest rate must be maintained at a level that restrains overall demand which limits foreign currency outflows. The CBSL was able to acquire reserves until it loosened policy in October 2024. The net reserve position has since eroded.
The CBSL therefore has an explicit internal anchor (inflation) and an implicit external anchor (the exchange rate). The dual anchors inevitably create conflicts which intensify over time and can manifest as a balance of payments crisis. External shocks such as the Trump tariffs will worsen the conflict. If inflows slow, the resources available for savings decline, necessitating a higher interest rate to curb investment and divert resources to build reserves. Yet if CBSL is targeting a 5% inflation, it will feel compelled to lower rates, hence the conflict. A low ceiling for inflation minimises the conflicts between objectives and thus the likelihood of a crisis.
In theory, a country with a flexible exchange rate should not suffer a balance of payments crisis as the central bank can simply ‘let the exchange rate go’. This is not possible in practice because large exchange rate swings can cause major disruptions to the economy. Further, in an open economy, the exchange rate is an important determinant of the CPI and therefore some exchange rate management is necessary to meet a CPI inflation target. This implies a commitment to intervening in the foreign exchange market if necessary. As an IMF working paper notes, there is thus a case for what it terms ‘exchange anchored inflation targeting’.
The paper notes a universal preference among practitioners in Less Developed Countries to carefully manage the path of the exchange rate (Mishra et al., 2010, quoted in Airaudo et al, 2016).
If inflation reaches 7%, by age 75, a retiree would have lost 74.16% of their savings’ value. If inflation were 2%, the loss would be 32.7%.
The Paper Admits That:
“The stylized fact that virtually all LDCs now support IT with tight management of the exchange rate is a serious problem for existing theory (Airaudo et al., 2016).”
But Concludes:
“Our results may prove controversial, but at least they reconcile theory with current practice. Confronted with the stylized fact that LDCs overwhelmingly reject the conventional wisdom to float in favor of tight management of the exchange rate, we answer: ‘What is the puzzle? Exchange-rate-anchored IT works both in practice and in theory, while flexible exchange rate IT is problematic in theory and has performed poorly in practice.’”
Savings are of particular concern in Sri Lanka because of its rapidly ageing population — by 2042, almost one in four people is expected to be elderly.
Policy recommendation: A 2% inflation ceiling
Sri Lanka is emerging from the worst economic crisis in its history, the latest in a long line of similar episodes as evidenced by sixteen previous IMF programmes. The Central Bank has done an admirable job in bringing inflation under control. The challenge now is to preserve that hard-won stability. In a turbulent global environment, the stakes could not be higher.
Volcker says reasonable arguments can be made regarding 2% inflation as an upper limit for stability. The CBSL should adopt this standard by setting 2% as a strict ceiling. Note that is not a target, but a limit. The CBSL should not allow inflation to exceed 2% but does not need to work to achieve 2% inflation — any level lower than this would be acceptable. This allows CBSL the flexibility to run deflationary policy.
The CBSL itself warns of the difficulty in maintaining low inflation. In a time of global turmoil, policy should err on the side of caution. A low, fixed ceiling with no upward flexibility minimises the danger. Overshooting from a low ceiling is far less harmful than overshooting from a high one. The priority should be to prevent the next crisis, as even small deviations from a low inflation ceiling raise that risk and could undermine our fragile recovery.
With inflation still low and the external position relatively stable, this is the ideal time for a modest, pre-emptive rate adjustment to support a new 2% ceiling. Acting early would anchor expectations before pressures build, requiring only a small tightening to secure long-term stability. While some may worry that a lower inflation ceiling implies permanently higher interest rates, the opposite is more likely over time: once credibility is established, inflation expectations fall, allowing interest rates to stabilise or even decline. A clear, credible ceiling, enforced with timely policy, reduces the need for disruptive interventions later and minimises risk of another BoP crisis.
Policymakers Should Heed the Warning from Volcker:
“A lesson from my career is that such success can carry the seeds of its own destruction. I’ve watched country after country, faced with damaging inflation, fight to restore stability. Then, with victory in sight, the authorities relax and accept a ‘little inflation’ in the hope of stimulating further growth, only to see the process resume all over again. The sad history of economic policy over much of Latin America offers too many examples.”