Reserve money or the monetary base is made up of circulating money and commercial bank deposits in the central bank is the money used to clear final transactions in an economy.

Precarious Balance

However, economic analysts have warned that in the context of defending a US dollar peg, reserve money targeting would either crowd out both the government and private sector or result in currency troubles.

In the first half of the year, there was severe crowding out as the central bank collected foreign reserves, and in the second half of the year, currency pressure has emerged as an effective loosening of policy took place and the central bank rapidly lost reserves.

In a bid to maintain reserve money, the central bank has pumped in more than 90 billion rupees of money in the past two months, indicating a loss of similar or larger amount of dollar reserves.

Meanwhile, consumer inflation has fallen to 20.2 percent in October from a high of 24.3 percent a month earlier, and 28.2 percent in June 2008.

Sri Lanka's controversial core inflation index, which lagged behind 'headline' inflation for months, had also belatedly started to fall.

Money Growth

"These favourable developments resulted from the continuous tight monetary policy stance of the Central Bank and improvements on the supply side," the monetary authority said.

A global fall in commodity prices is expected to help inflation. Domestic fuel prices have been cut. Export prices of tea and rubber have also fallen.

The central bank projects year-end inflation to be 17-18 percent and is promising single digit inflation during 2009.

"The tightening of the Central Bank’s demand management policies has been effective in containing the expansion in domestic credit and monetary aggregates as evidenced in the deceleration in the growth of both reserve money and broad money," the Central Bank said.

Broad money defined as M2b grew by only 10.6 percent in the year to September 2008, compared with 16.6 per cent in December 2007 and 17.8 per cent in December 2006.

"The sustained deceleration in the growth of monetary aggregates would help ease inflation further in the forthcoming months," the central bank said.

Peg Troubles

But analysts have warned that central bank currency defense and liquidity injections may de-stabilize its monetary program as quantity targeting gives good results only when the exchange rate is allowed to float as freely as possible.

The International Monetary Fund has also advised Sri Lanka to break a dollar peg. The peg has already been loosened from 108 to 110 rupees a dollar.

Central Bank says the rupee has come "under some pressure" due to a sell off by foreign holders of treasury bills and the central bank has spent reserves to have an "orderly management".

Central Bank has slapped controls on forward contracts and raised margin deposit requirements of some products to help contain import demand.

Analysts say such measures have a somewhat similar effect on the economy as an increase of a statutory reserve ratio (SRR) and can help contain import dollar demand at least for a short time.

The Central Bank had earlier cut the reserve ratio releasing an estimated 7.5 billion rupees to the system.

But such measures can also severely backfire on the service sector, and can result in an economic downturn as wholesale and retail trade contracts.

The Central Bank has said the economy is likely to expand by 6.0 to 6.5 percent in 2008.

Updated