"[T]here is now a need to stimulate the domestic economy, particularly in the light of the gradual moderation in headline inflation and subdued demand pressures in the economy," the Central Bank said in its May monetary policy review.
The IMF has warned against loosening policy, saying Sri Lanka has had a history of high inflation from loose policy.
But Central Bank said the economy has seem to have developed a greater capacity to have high growth without fuelling inflation and international commodity prices were also seen softening.
The central bank said after spiking sharply in April, its holdings of Treasuries which represents printed money on the asset side of its balance sheet has started to fall. In April the Central Bank is usually forced to print money to pay salary advances of state workers.
"Nevertheless, the situation has improved during the past few weeks with the Government being able to settle a part of its dues through the retirement of Treasury bills held by the Central Bank, with the outstanding Treasury bill stock declining to Rs. 119 billion by end April," the Central Bank said.
"In this regard, a pick-up in domestic economic activity in the balance part of the year is expected to generate higher tax revenues, thereby helping achieve the fiscal targets set out for the year.
"Moreover, the expected moderation in market interest rates would also ease the financing cost of the government debt, thus leaving greater resources to finance the public investment programme of the government.:
But a lowering of market rates which may boost private credit could also have an opposite effect. If credit markets are left to operate on their own such effects will be balanced through a market clearing interest rate.
But if at the time, the Central Bank injects money through reverse repo auctions, the reverse repo window, or outright purchases of Treasuries which is the most dangerous action, the exchange rate may weaken and inflation may also pick up, analysts say.
By May 05, excess liquidity in the banking system had disappeared and some banks had started to borrow from the reverse repo window at the then rate of 9.5 percent which was cut to 9.0 percent Friday.
The central bank was still withdrawing liquidity overnight through a repo auction at 8.3 percent, which had become the effective policy rate and which may fall now.
However under Sri Lanka's domestic due to existence of a wide corridor the effective rate can move closer towards the 9.0 percent ceiling rate if credit picks up.
The Central Bank said it is also extending the period banks can operate short reserves for two weeks instead of one.
It will allow banks operate for a longer period after giving credit without meeting their statutory reserve requirement of 8.0 percent with fresh deposits or borrowing from others or through or through the reverse repo window.
When liquidity is short such a move could also represent a loosening of policy, at least until the banking system re-adjusts, analysts say.
In 2011 and 2012 credit pressures built up and the Central Bank had to print money through outright purchase due to losses of energy utilities being financed with reverse repo window, reverse repo auctions and ultimately outright Treasuries purchases.
A 9.0 percent policy rate however is one of the highest in Asia.
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