"Point-to-point inflation would come down to below 20 percent," central bank governor Nivard Cabraal told LBO.

After peaking at 28.2 percent in June, consumer inflation in Colombo had fallen to 24.3 percent in September.

The central bank is also banking on economic growth of "between 6.5 to 7.0 percent" in 2008, Cabraal said.

But an outflow of foreign reserves and liquidity injections made by purchasing treasury bills with printed money is threatening to de-stabilize the monetary system.

By Friday the Treasury bill stock of the central bank - a red flag for inflation watchers - had rocketed to 32 billion rupees, from almost nothing barely three weeks ago, showing the magnitude of liquidity injections and reserve appropriations that have taken place.

Up to mid September 2008, the central bank had maintained tight monetary policy by sterilizing excess liquidity and keeping to a tight monetary program.

But from September 18, the tide has turned, and the bank has engaged in heavy cash injections almost on a daily basis.

The Central Bank Governor spread unease among market participants last week at a meeting, saying the central bank had "space" to absorb Treasury bills and print money.

But a central bank that maintains a peg with a foreign currency – in Sri Lanka's case the US dollar - has no space to buy Treasury bills and print money, except perhaps in back-to-back transactions relating to settle state liabilities, which happens outside the commercial banking system.

On Thursday and Friday the central bank was heavily intervening in foreign exchange markets with a state bank selling dollars at 108.00 rupees.

Such interventions reduce foreign reserves and also take money out of the monetary base (reserve money) which are then topped up by liquidity injections.

It represents a loosening of monetary policy, though some central bankers in countries that have high inflation and currency problems find the concept difficult to grasp.

The process, known as 'sterilized intervention' unwound the central bank's 2007 monetary program when inflation rocketed despite money targets being met.

The vicious cycle of interventions and sterilization was broken by 'floating' the rupee in late August 2007, but its effects were felt through high inflation well into the next year.

Both Pakistan and Vietnam fell victim to the same phenomenon in the past year.

Unless the currency is allowed to float, analysts warn that more foreign reserves would be lost and the bank's monetary program would also go off track.

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