On September13, the Central Bank raised its repurchase and reverse repurchase rate by quarter-point, citing concerns about an increase in broad money growth due to expansion in private sector credit.
Both rates were raised by half a percentage point on June 15 and a quarter-point on May 13.
The bank expects financial institutions to raise the deposit rates immediately thereby strengthening the effectiveness of these policy measures.
Curbing Inflation
"A deceleration in monetary expansion and a further containment of inflation and inflation expectations are expected with these measures,” the statement said.
Sri Lanka's average consumer inflation measured by the most widely Colombo Consumer Price Index moved down 12.1 percent in November after peaking at 12.8 percent in August, but year on year inflation has been moving down faster to 9.
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1 percent.
The broader Sri Lanka wide index fell to 12.7 percent in October after peaking at 14.5 percent in July, while the year-on-year figure fell to six percent.
However, money supply growth remains high, fueled by credit expansion and improving foreign reserves.
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Real interest rates have been negative by a wide margin until recently, making monetary policy measures ineffective, though analysts say the latest rise would help Central Bank regain a small measure of control.
The treasury recently converted its overdraft with two state-owned commercial banks to bonds, which if sold out of the banking sector is also expected to help reduce money supply growth.
The island's Central Bank has forecast year-end inflation of around 10.0 percent, which is the highest in South Asia.
Critics say inflation in the tropical island torn by ethnic conflict and with coastlines devastated by last December's tsunami has been fuelled largely by expansionary fiscal policy 2004 and inadequate tightening of monetary policy, in the face of capital inflows in 2005.
Despite high inflation, the bank said the economy's growth momentum was continuing due to a recovery in sectors such as tourism and fisheries, which had been hurt by the tsunami.
"The adverse impact of the tsunami disaster on the economic activities in some sub-sectors of the economy is dissipating gradually," the bank said.
The 25-basis-point rate hike was a surprise. Before the decision was announced, market players were expecting a rate hike early next year, as inflation was showing signs of easing up.
"This may be a pre-emptive strike to prevent inflation going up further next year," noted Economist and Chief Investment Officer of Boston Asset Management, Channa Amaratunga.
Eye on bonds
"It's like a teaser, perhaps an indication that they will raise rates further, because the government has now issued an inflation linked bond. So they will be careful to control inflationary pressures," says Dudeepa Ratwatte CEO First Capital Asset Management.
Sri Lanka this month, issued its first-ever inflation-linked bond, a move analysts said should spur the government to attempt to keep a lid on the nation's hefty inflation rate.
The Rs. 22 billion three-year issue, carries a 11.2 percent coupon rate in the first year. The coupon rate is pegged at one percentage point above the country's annual inflation rate for the remaining two years.
The new president Mahinda Rajapakse's welfare laden budget is also likely to fuel inflationary pressures next year.
Rajapakse, who is also the country's finance minister, incorporated spending promises made during his election campaign by raising welfare benefits and fertiliser subsidies under a revised 2006 budget released Dec. 8.
He said the budget deficit will widen to 9.1 percent of gross domestic product next year, from a forecast of 8.5 percent of GDP this year.
"Subsidies could fuel inflation through increased spending," Amaratunga said.
The next monetary policy announcement is scheduled for January 17.
Please click to read the Central Bank's monetary policy statement for December
-Mel Gunasekera: mel@vanguardlk.com