CB expected to maintain policy rates allowing prior actions to take effect

• Monetary Policy Board to convene today for eighth time for this year to decide on policy rates
• It has delivered cumulative 550bps reduction up to now on three occasions this year
• First Capital Research assigns 60% probability for CB to leave key policy rates unchanged

As the Monetary Policy Board of the Central Bank convenes today, for its eighth monetary policy meeting of the year and the second under the new Central Bank Act, there is a widespread expectation in the market that the rate-setting committee will maintain the current stance. 

This comes after delivering their third rate cut in early October, resulting in a cumulative reduction of 550 basis points in key policy rates since the pivot to a dovish stance in June this year.

Releasing its customary pre-policy analysis, First Capital Research assigned a 60 percent probability for the Monetary Policy Board to leave the key policy rates unchanged, allowing more time for the previous policy easing to take effect in the real economy. 

Monetary policy sometimes has long and variable lags and hence the past monetary policy actions still could be feeding through the economy.

First Capital cited the decline in market lending rates and growth in private sector credit, which grew for the fourth month in a row through September, as indicators of how the earlier policy easings have influenced key areas in the economy.

However, it cautioned against further easing, due to certain upside risks to inflation coming from energy and utilities price revisions and the impending increase in the value-added tax slated for next year.

Despite a slight uptick, inflation for October, measured by both the Colombo Consumer Price Index and National Consumer Price Index, came in at 1.5 and 1.0 percent, respectively, much lower than the 5 percent inflation target of the Central Bank.

Meanwhile, First Capital further said further policy easing could stoke excessive demand for private credit, potentially overheating the economy, as credit appears to have started flowing back into the real economy, after about a hiatus of 18 months.

It also cautioned against further policy easing, citing the stickiness shown by the secondary market bond yields since the last policy rate cut in October and the limited progress made in the external reserves.

Hence, First Capital believes that any more policy easing may not yield the desired outcome of further decline in bond yields, until a resolution is reached on external debt restructuring.

It pointed out that despite the secondary market bond yields responding to domestic debt optimisation back in July, prompting a sharp 700 to 1000-basis-point decline in yields in its aftermath, a similar response hasn’t come through despite the 550-basis-point cuts in key policy rates post the domestic debt restructure.

However, making a case for a rate cut, First Capital cited the need for more support to accelerate the nascent economic recovery, the need to make debt more affordable and creating a more conducive business environment as compelling reasons.

It also cited the US Federal Reserve, which has nearly come to the end of its rate-hiking cycle, as another reason for countries such as Sri Lanka to consider easing their monetary policy, as it could slow or end the run-up in the dollar, ameliorating the pressure on frontier markets, which saw foreign exchange outflows thus far, in response to the aggressive Fed tightening campaign.

First Capital broke down its 40 percent probability for a rate cut between 50 bps, 100 bps and 200 bps, with the probabilities of 10 percent and 15 percent each for the latter two.

The eighth or the last monetary policy for this year will be announced on Friday (24) morning. 

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