This study examines the impact of monetary policy shocks on output, prices and interest rates in Sri Lanka during the period 2003–2012. It finds a strong transmission of policy rate shocks onto the money market rates and the government securities market yields. However, banking sector interest rates exhibit a smaller and slower impact compared to money and government securities market rates. The study also finds a weak policy interest rate transmission onto the real sector and prices. The direction of relationships between variables and policy shocks is in conformity with the existing theoretical and empirical priors. The existence of a large informal economy, volatile excess market liquidity, shallowness of financial markets, relatively less flexible interest rates on deposit and loan products, and fiscal accommodation by monetary policy at times are identified as reasons for weak transmission.

BACKGROUNDHaving recognised potential benefits, the Central Bank of Sri Lanka (CBSL) has announced that it is transitioning towards an Inflation Targeting (IT) framework. As an interim arrangement, the CBSL has adopted an enhanced monetary policy framework, which, it claims, has features of both Traditional Monetary Targeting (TMT) and Flexible Inflation Targeting (FIT) frameworks. Under this, the CBSL is said to focus on stabilising inflation in mid-single digits over the medium term, while supporting the growth objectives and flexibility in exchange rate management. Instead of reserve money, the CBSL has started using average weighted call money rate (AWCMR) as its operating target. It also claims that macro projection capacity is being strengthened at the CBSL with a view to transition towards IT.This move has been backed by the 2016 program facilitated by the International Monetary Fund (IMF) as well. One key pillar of the Extended Fund Facility (EFF) is the transition towards IT and flexible exchange rate. The inclusion of a Monetary Policy Consultation Clause in the EFF is a clear signal of the direction. Under this Clause, if the year-on-year inflation falls outside the outer bands specified, the authorities will have to complete a consultation with the IMF which would focus on: (i) the stance of monetary policy and whether the Fund-supported program remains on track; (ii) the reasons for the deviation; and (iii) on proposed policy response. When the consultation with the IMF is triggered, access to Fund resources would be interrupted until the consultation takes place and the relevant program review is completed.This paper explores the need to tackle fiscal dominance over monetary policy as a precondition for CBSL's implementation of IT. AN INTRODUCTION TO ITAn IT framework is one in which a numerical inflation target is publicly announced by a monetary authority (in the present case, the CBSL), which then commits to price stability as the primary goal of monetary policy, assumes accountability for the.