"The benefits of the improving macroeconomic structure would also raise the potential of the domestic economy to grow, and such potential should now be provided the space to materialise," it said in its August monetary policy statement.

"While inflationary pressures in the domestic economy have continued to be benign in the recent months, enhanced prospects for domestic agricultural produce have further improved the outlook for inflation."

The Central Bank said that it began easing its monetary policy stance in 2009 in order to stimulate economic activity considering the improving outlook for inflation.

Broad money (M2b) has decelerated in the recent months while macroeconomic conditions have remained stable.

"Market interest rates have adjusted downwards, although at a slower pace, in response to the easing of the monetary policy stance," the statement said.

"Yield rates on government securities in the primary market have declined during the recent months while the prevailing positive outlook for the economy has also made possible, the issue of Treasury bonds with maturities of up to ten years."

The central bank said other market interest rates have also declined, but that some lending rates are "yet to show a full adjustment".

In line with improving economic prospects and the gradual easing of credit conditions, credit to the private sector, which turned positive in March this year, increased to 6.2 percent by June 2010 from a year ago.

"Meanwhile, the risk of macroeconomic variables moving in an undesirable direction has now substantially abated," the statement said.

"The current developments also call for a reduction in the risk premia incorporated in lending rates of financial institutions, thus leading to the intermediation gap between lending and borrowing rates of the banks reducing further."

The Central Bank said it expects domestic credit conditions would continue to ease in line with its policy direction, "strongly supporting" the revival in economic activity currently underway.

Sri Lanka's 30-year ethnic war ended in May 2009 leading to an economic revival with growth forecast at seven percent this year.

"The Central Bank expects credit flows to the private sector to gather momentum during the remaining months of the year, alongside the anticipated pick-up in economic activity," the statement said.

"At the same time, the expected expansion in credit would serve to reduce the excess liquidity, which has built up in the money market over the past several quarters."

Updated