Reserve Bank Governor Raghuram Rajan seemed to link further rate cuts to the upcoming Budget on February 28. Delivering a message to the government, Dr Rajan said the RBI would be closely watching the Budget before deciding its next policy move.
In particular, the central bank seems interested in the government's fiscal consolidation path. "The government has intent of producing a solid Budget. The finance minister and ministry officials have reiterated their desire to stick to the budgetary target of this year," Dr Rajan said.
For the 2014-15 fiscal, the government has set a target of narrowing the fiscal deficit to 4.1 per cent of GDP, which will be a seven-year low. According to the roadmap outlined by the Kelkar Committee, fiscal deficit has to restricted to 3 per cent of GDP by 2016-17.
But it's not the headline number that the central bank seems to be worried about. The quality of fiscal deficit, determined by the nature of government expenditure, will also be closely analysed. According to JP Morgan's India economist Sajjid Chinoy the composition of government spending is very important.
"A lot of subsidy, leakages on subsidy and very little public investment to boost supply can be causes of inflation. As a central banker you need to be worried about causes not symptoms," he said.
Mr Chinoy seemed to be echoing the Dr Rajan's sentiments, who earlier in the day had said, "We are not locked to a specific number or path (fiscal deficit) but the overall package whether it makes for high quality fiscal consolidation over time that clearly will impact inflationary forces we are worried about."
Mr Chinoy said it is not surprising that Dr Rajan has linked the monetary policy to the government fiscal policy stance. "Fiscal policy has been an elephant in the room and always had an impact on central bank's reaction function. An expansionary fiscal policy is a cause for inflation. The tighter fiscal policy the looser is the monetary policy the world over."
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