Pass-through of external shocks to inflation in Sri Lanka

A March 2008 International Monetary Fund (IMF) study on the pass-through of external shocks to inflation in Sri Lanka questions the sources attributed to the recent sharp increase in inflation in the country. According to the study, inflation rose from about 7 percent to 19 percent between the beginning of 2006 and the end of 2007.

A number of shocks, both external and domestic, have contributed to this increasing including rising international oil prices, demand pressures and adjustments in administered prices. On the external shocks, it says the exchange rate has long been viewed in monetary literature as an important channel of monetary transmission.

The importance of the exchange rate warrants an assessment of the extent to which it affects domestic inflation and the implications of its pass-through on the effectiveness of domestic monetary policy in containing inflation. The theoretical and empirical literature has also identified many other channels though which inflation can be affected including the credit channel, the asset price channel, and through inflation expectations and wages.

The paper finds incomplete pass-through of external shocks to domestic price inflation in Sri Lanka. Pass-through to consumer prices is about 10 percent during the first month and rises gradually to a maximum of about 40 percent in four months. Pass-through of oil price shocks is much smaller and even negative, rising from about 2 percent during the first month to about 6 percent in four months. Pass-through of import prices rises from about 4 percent in the first month to about 28 percent in three months. The presence of administered prices in Sri Lanka helps to partly explain low and incomplete pass-through. External shocks appear to explain about 25 percent of the variation in consumer prices and about 32 percent of the variation in core inflation, suggesting that other shocks that are likely more domestic in nature explain most of the variation in inflation in Sri Lanka.

Inflation and the Exchange Rate

Since late 2006, Sri Lanka's inflation has increased sharply relative to other economies in the region. The sharp increase in inflation compared to other countries in Asia points out that increases in oil prices in the recent past (a common shock to most economies in the region) cannot explain most of the increase in inflation in Sri Lanka.

The recent depreciation of the Sri Lanka rupee partly reflects rising inflation. Since late 2005, the rupee gradually depreciated, partly reflecting a decline in export growth and increase in import growth. However, the rupee remained stable in the second half of 2006 - during a period when inflation was rising sharply, the trade balance deteriorating and gross reserves (in months of imports) falling – due to heavy intervention by the Central Bank of Sri Lanka (CBSL). The rupee further depreciated from January 2007 onwards as intervention eased.

The IMF paper finds incomplete pass-through of external shocks to inflation in Sri Lanka. Using impulse response functions and variance decompositions derived from a recursive VAR model, the paper finds that pass-through to consumer prices rises from about 10 percent in the first month of the shock to about 40 percent in six months. The bulk of pass-through occurs in the first four months of the shock. Pass-through of external shocks to wholesale prices is more pronounced compared to pass-through to consumer prices implying that the impact of external shocks declines as one moves down the distribution chain. Also, the impact of the oil price shock on prices is rather small and negative, partly reflecting implicit and explicit oil subsidies that contain the impact of oil prices on inflation. In a parallel model, the study finds that pass-through of oil prices shocks is slightly larger on administered prices compared to consumer prices.

Given low pass-through of external shocks and that external shocks explain a small percentage of the variation in inflation, domestic shocks likely play a more significant role on inflation in Sri Lanka. With external shock not playing a major role in ifluencing domestic inflation, domestic policies can be very important in containing inflation.