Inflation vs. Stability: Has CBSL’s Rate Cut Pushed Us Too Far?

Interest Rate Cuts: What’s Truly at Risk?

A critical article reviewing the Central Bank of Sri Lanka’s (CBSL) recent decision to reduce rates was published by EconomyNext on July 14, 2025. The piece expresses concerns that it may risk the country’s already unstable economic recovery. The article, authored by Bellwether, argues that even a small reduction of 25 basis points may have significant long-term consequences, particularly at a time when private credit is increasing and deposit rates are rising. The main concern is that this rate cut might weaken monetary policy, affect reserve accumulation, and bring Sri Lanka closer to a second default.

Understanding the Risk: Why It Matters

Image from: https://cdn.newsfirst.lk/english-uploads/2025/07/WEB%20(11)-796646.jpg

The CBSL uses its single policy rate (OPR) to set market rates as part of its inflation targeting mechanism. Reducing this rate at a time when the economy is already displaying signs of credit recovery could encourage excessive borrowing, discourage banks from holding government securities, and possibly lead to reserve losses or capital outflows as a result of increased demand for imports.

The article points out that keeping interest rates low during a credit recovery may:

• Discourage banks from investing in Treasury bonds

• Result in a reduction of foreign reserves as more money is directed towards imports 

• Would result in macroeconomic instability by indirectly driving inflation

Foreign investors may become anxious as a result and cause them to take their funds out. This is a major risk for a country like Sri Lanka, which is still getting over a recent debt crisis. We may be getting closer to another economic collapse if we continue to lose reserves.

The Classical Economic Perspectives

Interestingly, the article points out modern macroeconomic models set up by organizations like the IMF, stating they are inaccurate and misleading. It argues that these models often ignore proven classical economic principles, such as those from David Hume, which emphasize the significance of strict monetary policy when accumulating foreign reserves. The article argues against using concepts like potential output and core inflation to support interest rate cuts, as they may not accurately reflect real economic risks. This concern grows especially serious now, given the lack of transparent Balance of Payments (BOP) data in Sri Lanka. 

What do Theories Say?

Liquidity Preference Theory (LPT)

This theory implies that the interest rate is decided by the demand and supply for money. Interest rates decrease and borrowing becomes lower in cost when the central bank injects more money into the system (through methods like cutting interest rates or open market operations).

However, judging by Sri Lanka's current situation, if this persists when the economy is already accelerating or recovering, it raises liquidity beyond what is required, resulting in inflation, currency depreciation, and even import increases. An excessive amount of money pursues limited commodities, which raises prices rather than increasing output. The rupee depreciates under certain situations, and reserves may be drained to keep the currency stable. 

Final Thoughts

image from factseeker.lk

This article is a valuable reminder of the complications behind interest rate decisions. Although short-term rate cuts may seem like a good way to keep inflation under control, they can have unintended consequences such as weakening the rupee, losing reserves, and worrying investors. The most stable direction for Sri Lanka's recovery may be to rely on solid economic fundamentals rather than theoretical statistical models, as CBSL thinks about the next strategy.

References

 https://economynext.com/sri-lanka-central-bank-skating-on-thin-default-ice-with-latest-rate-cut-230410/

https://www.cbsl.gov.lk/sites/default/files/cbslweb_documents/press/pr/press_20250522_Monetary_Policy_Review_No_3_2025_e_Mw8b9.pdf?utm_source=chatgpt.com

https://renessans-edu.uz/files/books/2024-12-02-07-28-43_11de1f1c6ed37dd845afc66e51ccd286.pdf

https://competitionandappropriation.econ.ucla.edu/wp-content/uploads/sites/95/1970/01/HumeOfMoney.pdf

Written by,

Devni Weeramuni (236136B)  

- July 27, 2025