The Reserve Bank today cautioned the government against a stimulus package to revive the sagging growth, arguing that breaching the fiscal deficit target will fire up inflation and hurt long-term macroeconomic stability.
It pointed out that farm loan waivers, combined with a potential stimulus which the government is mulling now, can result in a 1 percentage point slippage in fiscal deficit which is pegged at 3.2 per cent for 2017-18.
"Such a slippage can stoke inflation by 0.50 per cent on a permanent basis," RBI warned.
A slippage of 0.50 per cent on the 3.2 per cent target can result in inflation moving above 0.25 per cent of its baseline estimate, it said.
The combined fiscal deficit of the Centre and states is over 6 per cent and "the national fiscal stance can hardly be described as tight", it said.
"In other words, we should be very cautious lest fiscal actions undercut macroeconomic stability," RBI Governor Urjit Patel told reporters at the customary post-monetary policy interaction.
As of August end, the government has already run up 96.1 per cent of its fiscal deficit targets for 2017-18 as it has advanced spending in core infra sectors like roads, ports and railways.
In the fourth bi-monthly Monetary Policy Report 2017-18 today, RBI left the key lending rate unchanged at 6 per cent and reverse repo at 5.75 per cent, despite calls for a cut to boost growth.
It has revised upwards its retail inflation target to up to 4.6 per cent for the March quarter citing risks from hikes in HRA for DA for government employees and possible fiscal slippages arising from farm loan waivers and potential stimulus measures.
In the face of a steady decline in growth numbers -- GDP expansion slipped to three year low of 5.7 per cent for the June quarter -- government is planning to unveil a fiscal stimulus. The GDP growth has been falling consistently for the past six quarters.
RBI, which is tasked with maintaining inflation at 4 per cent, plus or minus 2 per cent, under the inflation targeting framework, has been repeatedly flagging concerns on fiscal slippages along with the farm loan waivers which it fears will wreck the credit culture.
The inflation number is also watched very keenly by global rating agencies while forming their view on the sovereign credit. An adverse outlook or rating action can increase the borrowing costs for the government.
All the major global rating agencies have placed the country rating at 'BBB-', which is just one notch above the junk grade, although with a stable outlook.
Referring to a 2005 study, the central bank said that "higher fiscal deficits per se can lead to an increase in inflation expectations and actual inflation". It underlined that there is a long-running relationship between fiscal deficits and inflation in the country.
Empirical estimates, as per RBI, suggest "that an increase in fiscal deficit to GDP ratio by 100 bps can lead to a permanent increase of about 50 bps in inflation".
In upside risks to its inflation forecast, where it expected price rise to move up to 4.6 per cent by the March quarter of 2018 from 3.4 per cent in August, RBI flagged possible fiscal slippages due to farm loan waivers and potential stimulus measures.
Other upside risks to its estimate include the expected increases in salaries and allowances by states and short-term uncertainty because of the GST rollout.
However, when asked if an addition of 100 bps to inflation may result in no rate cut, Patel said inflation risks are balanced on both sides and pointed to the positive factors like a possible dip in commodity prices and food inflation staying under control.
(This story has not been edited by Business Standard staff and is auto-generated from a syndicated feed.)