Central Bank likely to ease rates further as economy slows – First Capital Research

The Central Bank is expected to cut its key interest rates at its monetary policy meeting today, with a 60 percent probability for a reduction, according to a pre-policy analysis by First Capital Research (FCR). 

FCR forecasts a 50 percent chance that the Central Bank will lower the rates by 25 basis points, while assigning a 10 percent probability to a deeper cut of 50 basis points. However, the firm also sees a 40 percent chance for the Central Bank to hold the rates steady, to monitor the global and domestic developments more closely.

The Central Bank’s policy decision will be announced tomorrow, July 23. 

“(We believe) there is a 60 percent probability for the Central Bank to reduce the rates … offering further stimulus to accelerate the economy. However, we believe there is a 40 percent probability for the Central Bank to maintain the policy rates, in order to allow further time to gain clarity on the domestic and global shifts,” FCR stated in its report.

FCR expects the Statutory Reserve Ratio (SRR) to remain unchanged, assigning an 80 percent probability, while giving a 20 percent chance for a 100-basis-point hike, citing the improved liquidity conditions.

Among the factors supporting a rate cut, FCR highlighted the need to support the potentially sluggish growth, more room for credit expansion amid limited state credit, subdued supply-side pressures in the second half of 2025 and slower-than-expected inflation.

Sri Lanka’s economy grew by 4.8 percent year-on-year in the first quarter of 2025, reaching Rs.3.5 trillion, driven by a 6.6 percent rise in consumption and 5.9 percent increase in investment income. However, on a quarterly basis, total consumption fell by 7.9 percent to Rs.2.3 trillion. The government’s capital expenditure for 1Q2025 stood at Rs.116 billion, well below the full-year budgetary allocation of Rs.1.3 trillion.

“We expect consumption to grow at a relatively slower pace, contributed by weak government spending … and relatively higher taxes and rising inflation are likely to reduce the disposable income,” FCR noted.

Credit to the economy grew by Rs.187.2 billion in May, mainly driven by the private sector credit growth. Despite this, total credit expanded by just 2.0 percent year-to-date. FCR believes there is still significant room for further credit expansion, without overheating the economy.

On the downside, FCR flagged concerns about the sluggish reserve buildup, volatile global conditions and potential risks of undermining private credit momentum, if policy is eased prematurely.

Sri Lanka’s foreign reserves dropped to US $ 6.1 billion in June, from US $ 6.3 billion in May, with further outflows of about US $ 422 million anticipated by October. While the release of the fifth tranche of the International Monetary Fund funds in July provided temporary relief, the rising import demand could limit the Central Bank’s ability to absorb foreign exchange.

“A premature rate cut may impair the private credit growth momentum,” the report cautioned, citing the sticky treasury bill yields and banks’ continued preference for government securities over private sector lending.

FCR also pointed to key indicators ahead of the policy decision, including the Central Bank’s holdings at Rs.2.5 trillion, inflation at -0.6 percent in June, GDP growth of 4.8 percent in 1Q2025 and a balance of trade deficit of US $ 472.5 million in May.

At its last policy meeting on May 21, the Central Bank cut the Standing Deposit Facility Rate (SDFR) and Standing Lending Facility Rate (SLFR) by 25 basis points to 7.75 percent, aiming to steer inflation towards the 5 percent target while supporting economic recovery.