Sri Lanka's inflation accelerated from low single digits after the island's soft-pegged Central Bank, sterilized foreign exchange sales with printed money, worsened a credit bubble and made the rupee fall nearly 18 percent over the past year.
However bank credit is now easing. Past experience has shown that inflation eases as credit slows or contracts following a balance of payments crisis, especially if the exchange rate also strengthens.
Sri Lanka's exchange rate however has not strengthened despite strong capital inflows, because the monetary authority had bought the dollars and created liquidity, preventing a strengthening of the exchange rate.
Analysts have urged the Central Bank to gently sterilize foreign exchange purchases (reversing the cycle that occurs in a balance of payments crisis), and push the exchange rate up to bring inflation down.
The Central Bank has sterilized some of the inflows with the outstanding Treasury bill stock falling by about 20 billion rupees over the past three months indicating that no major demand pressure has been added to the economy by the monetary authority.
Currency depreciation inflates the price of traded goods (imports and exports) and eventually feeds into the non-trade sector.
There are emerging signs that the depreciation is getting entrenched in the price structure of the island and feeding into the non trade sector, which analysts say underlines the urgency for the central bank to strengthen the exchange rate.
Sri Lanka's renewable power producer earlier this week called for higher tariffs to be paid to them by the power utility as capital cost of equipment increased due to currency depreciation.
The central bank has insisted that it can keep inflation below 10 percent by the end of the year.