Moody’s sees room for Central Bank to cut rates as inflation eases

• Says autonomy under new MLA and transition to inflation targeting regime to enhance monetary policy effectiveness 
• Expect inflation to pick up gradually to about 4.5% by end of 2018, supported by changes in administered prices and recovery in economic growth
• Moody’s  maintains a B1 rating on Sri Lankan sovereign with ‘Negative’ outlook

Moody’s Investors Service (Moody’s)  said the Central Bank has room to be more accommodative in their monetary policy, as the planned changes to the Monetary Law Act (MLA) are expected to enhance monetary policy effectiveness, helping to tame inflation while preventing fiscal dominance. 

Sri Lanka’s Central Bank is bringing amendments to the Monetary Law Act of No.8 of 1949, the legislation governing the activities of the Central Bank and its Monetary Board, clipping the voting powers of the Finance Minister at the Monetary Board while giving much needed autonomy to the Central Bank to lean against any fiscal excesses by the government.

In April this year, the Cabinet approved a policy note that included measures such as setting price stability as the Central Bank’s primary objective and ensuring operational autonomy by removing Finance Ministry’s voting rights in the monetary policy formulation process. 

The International Monetary Fund (IMF) expects the amended bill to be submitted to Parliament by March 2019.

“Looking ahead, the planned changes to the Monetary Law Act should strengthen the credibility and effectiveness of Sri Lanka’s monetary policy, helping the Central Bank anchor inflation expectations and prevent fiscal dominance”, Moody’s said in their latest annual credit analysis on the Sri Lankan sovereign. 

The Finance Ministry Secretary holding voting powers at the Monetary Board acts as an important conduit between the government and the Central Bank for effective macro-economic management.

A harmonized monetary and fiscal policy has been made possible by this arrangement as an effective relationship between the two enables maintaining total demand in the economy at a level equal to the total supply— a difficult task to achieve price stability in the economy. 
But some argue that the Finance Ministry Secretary’s presence in the Monetary Board makes the Central Bank subservient to the Finance Ministry.

Meanwhile, Moody’s did not specify a timeline as to when the Central Bank could cut rates but their statements indicate the near-term time horizon. 

However, the rating agency’s assertion run against the widely-held beliefs that the Central Bank is operating with little headroom to cut rates and face headwinds both internally and externally to tighten more in light of rising United Sates’ bond yields. 

Moody’s recently cited slowing consumer price inflation and widening gap between the actual and potential GDP growth in Sri Lanka, as key reasons that prompted the Central Bank to cut rates in April. 

In April, the Central Bank cut its Standing Lending Facility Rate by 25 basis points to 8.50 percent but since then stayed pat through their wording turned more hawkish. 

Inflation measured by the headline national consumer price index slowed to 1.6 percent in April 2018 from 7.3 percent in December 2017. But since then it has steadily risen every month to 3.4 percent in July 2018. 

“We expect inflation to pick up gradually to about 4.5 percent by the end of 2018, supported by changes in administered prices and recovery in economic growth”, Moody’s said. 

The rating agency also pointed out that the flexible inflation targeting regime the Central Bank is transitioning into by December 2020 would also strengthen the monetary policy effectiveness while allowing the ongoing exchange rate flexibility in the near term. 

The Central Bank expects the inflation to be maintained at mid-single digit levels in the medium term within the 4 to 6 percent range under the new regime. 

“Consistent with its stated objective of improving exchange-rate flexibility in the short term and maintaining a more competitive real effective exchange rate in the medium term, Sri Lanka’s exchange rate has been allowed to depreciate over the past year with the CBSL intervening only recently (US$190 million net sales of foreign exchange in May and US$127 million in June 2018, respectively) to smooth volatility”, Moody’s added. 

 Moody’s, who maintains a B1 rating on Sri Lankan sovereign with a ‘Negative’ outlook, said that a rating upgrade is unlikely given the dominant government credit profile and country’s elevated exposure to debt refinancing risk.