Investigating Factors Affecting the Target Level of Inflation: The Case of Sri Lanka

Sri Lanka formally adopted a Flexible Inflation Targeting (FIT) monetary policy framework in 2020. Along with this transition, the target level of inflation has become a focal point for implementing FIT. This policy paper discusses several considerations when selecting a target for inflation in the context of Sri Lanka, such as the choice between headline and core inflation and the choice of the price index. It undertakes several descriptive and empirical analyses to arrive at the possible numerical value(s) of the target (or range). The results of these analyses suggest a point target for the Colombo Consumer Price Index (CCPI)-based year-on-year headline inflation at 5 per cent, with a margin of ±2 percentage points to be suitable for Sri Lanka for considering operationalisation of FIT under the Central Bank of Sri Lanka Act No. 16 of 2023 (CBA). 2 This exercise should be repeated periodically to assess whether the inflation target under the Monetary Policy Framework Agreement needs to be revised, especially as economic conditions continue to evolve.