A clarification by the IMF on its recent findings on inflation in Sri Lanka implies that the impact of monetary and fiscal expansion on current inflation would be even lower than the 16 per cent captured by the study and that the impact of food and energy prices could be even higher now as food and energy prices rose sharply and monetary and fiscal policies were tightened further since July 2007.

A statement issued by the Central Bank on May 2 said:

“In response to the clarifications made by the Central Bank of Sri Lanka (CBSL) on the scientific grounds on the validity of the findings in the recent IMF working paper on Pass-through of External Shocks to Inflation in Sri Lanka, Mr. David Burton, the Director of Asia and Pacific Department of the IMF has now issued an explanation to the media.

“During the discussion with the CBSL officials, the IMF admitted that money supply and output gap were the two variables that represent monetary and fiscal stimulus in the model used. The IMF has further clarified that monetary and fiscal expansion explains only 16 per cent of the variation in inflation, not 75 per cent as interpreted earlier. Accordingly, the IMF explanation implies that the impact of monetary and fiscal expansion on current inflation would be even lower than the 16 per cent captured by the study and that the impact of food and energy prices could be even higher now as food and energy prices rose sharply and monetary and fiscal policies were tightened further since July 2007.

“The CBSL is thankful to the IMF for issuing an explanation in this regard as it would provide a more clear interpretation of the results of the Working Paper.

The statement issued by the IMF through David Burton, Director Asia and Pacific Department of the International Monetary Fund is given below.

“Our recent IMF Working Paper “Pass-Through of External Shocks to Inflation in Sri Lanka ” has attracted a lot of attention in Sri Lanka and we felt it would be useful to clarify some of the points raised by this discussion.

“The Working Paper examined the causes of inflation in Sri Lanka and used statistical analysis to investigate how much external shocks—events beyond the government’s control—contributed to inflation. The analysis indicated that such shocks explained about 25 percent of the variation in Sri Lanka ’s consumer price inflation between January 2003-July 2007, while 16 percent was explained by monetary growth and excess demand, and the rest by other factors, such as changes in government subsidies and volatile domestic food prices. Based on these findings, the paper concluded that domestic policies play a very important role in containing inflation—a view that is consistent with those of the IMF’s 2007 Article IV report on Sri Lanka and with the experience of other countries.

“In this context, it is important to note that the staff study only looks at data up to July 2007, and that it does not take account of the surge in world commodity prices that has been a big cause of the run up in headline inflation in Sri Lanka from 13.5 percent in July 2007 to 25 percent in April 2008.

“The Sri Lanka authorities have taken important steps to address this latest challenge. The government took a bold—in the sense of economically correct and politically difficult—step of allowing these price rises to pass through by phasing out food and fuel subsidies during the second half of 2007, and the CBSL has taken welcome steps to tighten monetary policy to combat inflation.

“The authorities are right to be concerned about the level of headline inflation, and the IMF supports their goal of bringing it down to single digits. This is why the 2007 Article IV report backed continued efforts to tighten monetary policy and to reduce the budget deficit.”