Explainer: Sri Lanka has negative inflation, but the govt wants to increase it. Here’s why

Our neighbour Sri Lanka has logged a year-on-year consumer price inflation of -2% in December 2024, marking a remarkable rebound from its worst financial crisis in decades just three years ago when it recorded a staggering consumer price inflation of 67.40% (September 2022).

Boosted with $2.9 billion support from the International Monetary Fund (IMF) it secured in March 2023, the South Asian country has now made a full turnaround.

Its central bank set a new policy rate of 8% in November 2024, easing monetary settings to support further economic recovery. The island nation's economy is expected to grow by 4.5-5% in 2024, as per its central bank data.

Deflation and Sri Lanka

When a country experiences negative inflation, or deflation, it means that the overall price level of goods and services is decreasing.

In Sri Lanka's case, the consumer price inflation dropped to minus 2% in December, indicating that, on average, prices were 2% lower than they were a year ago.

Sri Lanka's inflation drops to minus 2% in December

The consumer price inflation measures the change in the price level of a basket of consumer goods and services purchased by households. It's often represented by the Consumer Price Index (CPI).

Sri Lanka's National CPI captures broad retail price inflation and is released with a lag of 21 days every month. This type of inflation reflects the cost of living for consumers and is a key indicator of economic health.

Here's an example: Let's say, in December 2023, the average price of a basket of goods and services in Sri Lanka was 1000 Sri Lankan Rupees (LKR). The year-on-year 2% consumer price inflation drop means that in

December 2024, the average price of that same basket of goods and services is 2% lower. So, instead of costing 1000 LKR, it would now cost 980 LKR.

This decrease in prices indicates deflation, where the overall price level of goods and services is falling. 

Sri Lanka also logged a 1.0% inflation decrease in the food category in December year on year.

For a Sri Lankan, this means that food prices were 1.0% cheaper than last December. Meaning, that if in December 2023, the average price of a basket of food items in Sri Lanka was 1000 LKR, in December 2024, the same basket of food items would cost 990 LKR on average.

Deflation can occur for various reasons, such as a decrease in demand, an increase in supply, or improvements in productivity. 

In Sri Lanka's case, aside from IMF support, some major elements contributing to decreasing the inflation rate are reductions in power tariffs and fuel prices.

With the government reducing household power tariffs by 20% earlier this month, the island nation is expected to experience a low inflation rate for the next six months, by when the govt plans to bring the rate up by 5% 
Under the latest revision, industries will get a reduction of 30% while businesses in the tourism sector, a key foreign exchange earner for the island nation, will see their power prices slump by 31%.

Why not keep it low all the time?

Deflation, while albeit has its perks, is not always a good thing. As the old saying goes, "Too much of anything is bad." The same is applicable here.

A prolonged deflation might be the cause of underlying economic problems like weak demand or financial stagnation. 

A long period of negative inflation can see consumer spending dropping, lower business profits, and even cause potential job losses.

It's a complex situation that requires careful management to ensure long-term economic stability.

Here's an example

One major fear regarding negative inflation is that if it prolongs and prices keep decreasing, people might start delaying their purchases, expecting prices to fall even further.

For example, suppose, Mr X was planning to buy a new smartphone in December. With the prices steadily dropping due to the deflation, Mr X, might now want to wait a few more months hoping to get it at a lower price.

If enough people decide to delay such purchases, businesses will eventually face losses. Faced with lower revenues and profits, companies might decide to reduce their production, lay off employees to cut costs or even shut down altogether.
 
This will result in job losses and higher unemployment rates, which will turn on another chain reaction towards an even deeper crisis.

With fewer people employed and earning money, consumer spending decreases even more. This creates a vicious cycle where reduced spending leads to lower business profits, which in turn leads to more job losses and further reduced spending. The overall economy can stagnate, making it difficult for the country to achieve economic growth and stability.