Policy rates increased to discourage cheap credit, keep inflation under check

Sri Lanka’s monetary authority yesterday decided to raise its key policy rates by 25 basis points making it further pricey for the banks to borrow, in a proactive measure to contain further rise in prices of the goods and services of the economy. 
While much of the price pressure in recent months stemmed from the supply side triggers such as the drought and the recent value added tax, the Central Bank said it wanted to avoid the economy getting into the vicious cycle of demand-driven inflation. 
When the money is cheap people are inclined to demand more from a stable stock of goods and services, creating demand-driven price pressure. 
Since the supply side constraints have already pushed up the prices in the economy, the Central Bank appears to think that it cannot afford to make matters worse by stoking 
higher demand.  After yesterday’s decision, the standing lending facility rate or the rate at which the banks borrow from the Central Bank rose to 8.75 percent and such high cost is now passed on to the consumer by charging higher rates effectively discouraging the borrowers. 
But the impact on the future borrowing costs from yesterday’s decision is likely to be limited as such policy rate hike or even more has already been priced in the lending rates and the massive government borrowings are anyway putting an upward pressure on the interest rates. 
Meanwhile, the standing deposit facility rate or the rate at which the Central Bank absorbs excess liquidity from the banking sector was also increased to 7.25 percent. But the statutory reserves ratio was left unchanged at 7.50 percent. 
The largely expected hike in key policy rates came slightly over a week since the United States Federal Reserve raised its treasury yields by a quarter percentage point. 
It appears the Monetary Board thinks it was prudent to maintain the same interest rate differential between the US and Sri Lanka to curb anymore foreign outflows from the government securities market. 
The decision by the Monetary Board was a strong signal that the Central Bank stood guard against the monetary excesses such as more than expected credit growth and the national inflation which spiked to 8.2 percent in February. 
Although the private sector credit growth in January 2017 decelerated to 20.9 percent from 21.9 percent in December 2016, massive government borrowings during the period have scuttled the efforts by the Central Bank to ease off the monetary aggregates. 
As a result the broad money growth remained high at 17.7 percent in January on a year on year basis albeit less than 18.4 percent in December 2016 but the Central Bank appears not to be pleased with the pace of deceleration. 
“Considering the above developments, the Monetary Board, at its meeting held on 23 March 2017, was of the view that further tightening of monetary policy was necessary as a precautionary measure, 

in order to contain the build-up of adverse inflation expectations and the possible acceleration of demand side inflationary pressures through excessive monetary and credit expansion,” the monetary policy statement said. 
Although the Central Bank thinks yesterday’s increase in rates is sufficient to arrest any fiscal and monetary excesses in the economy, some are of the view that the Monetary Board may have to continuously stay vigilant to further tighten given the fragile external sector of the economy and the future rate hikes by the US Fed.