Inflation as measured by the year-on-year change in the Colombo Consumers’ Price Index (base=2002), which reached 14.
4 per cent by end-2008, is expected to further decelerate to a single digit level before mid-2009, the bank said.
"The Central Bank expects inflation to remain at modest levels thereafter, guided by its policies aimed at monetary stability."
The bank said the pass-through of the reduction in the penal interest rate to market interest rates will help buoy economic activity and sustain economic growth in the face of declining external demand with the continuing global economic slow-down.
"The Central Bank expects banks and financial institutions to reduce their interest rates accordingly and pass the benefits of this reduction to customers," it said.
The Central Bank will continue to monitor movements in lending rates in order to reduce transaction costs.
The central bank said it has made arrangements to publish bank-wise prime lending rates from January 2009.
Growth in both the broad money supply (M2b) and credit to the private sector has declined to single digit levels of 7.3 percent and 9.2 percent, respectively, by end-November 2008.
"This deceleration of monetary aggregates coupled with the favourable developments on the supply side is expected to continue to impact favourably on prices as well as inflation expectations, thus enabling the Central Bank to ease its monetary policy stance somewhat in 2009."
The next regular statement on monetary policy will be issued on February 11, 2009.
The bank said in its monthly monetary policy review that it expects banks and financial institutions to cut market interest rates and that it will ease monetary policy further if inflation continues to fall.
"If the declining trend in price increases continues as expected, the Central Bank will consider further easing its monetary policy stance, enabling financial intermediaries to reduce the rates at which they lend to borrowers further.
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The unrestricted penal discount window rate now serves as a ceiling on overnight interest rates and as a benchmark rate for other market rates.
"The Central Bank has decided to ease its monetary policy stance in view of the declining inflation and inflation expectations as well as the gradual decrease in market interest rates including yields on government securities," the statement said.
"This reduction in the penal rate will lead to a further reduction in market rates of interest."
A separate 12.0 percent window, with restricted access as well open market auctions also around the same rate remains in place.
The bank said the significant decline in inflation over the past six months and the favourable outlook for inflation during 2009 has enabled it to facilitate a reduction in market interest rates.