Central Bank said inflation was falling, private sector credit was growing and the economy was growing faster than expected.
"Taking into consideration these developments in the economy the Monetary Board has decided to revise the policy interest rates downward," the central bank said.
"In response to this, lending rates of commercial banks are expected to adjust further downward, stimulating economic activity."
Twelve month inflation fell to 4.8 percent in June, though prices rose in absolute terms during the month.
The central bank said growth in broad money fell to 15.5 percent in May 2010 from 18.6 percent at the end of 2009.
From late 2009, excess liquidity and reserve money expanded causing concerns among inflation watchers who warned against a resumption of debt monetization.
Liquidity was also boosted central bank profit transfers.
The central bank later withdrew liquidity from the market.Analysts have said that Sri Lanka policy rates - which are among the highest in the world -are undermined by direct monetization of government debt.
Sri Lanka's rupee is strongly pegged to the US dollar as an external monetary anchor.
Under a deal with International Monetary Fund, Sri Lanka's state agreed to cap domestic borrowings to level seen two years ago.
Analyst say Sri Lanka could have lower interest rates and lower inflation like other dollar pegged countries in Asia, if ad hoc monetization of debt could be avoided.
Though central bank profit transfers took place in 2009 and early 2010, official data showed that last year the Central Bank had not increased the so-called 'provisional advance' of printed money to the government.
