Pay hike to stoke inflation, push up GDP: RBI report

At the same time, the central bank remained confident of meeting its March 2017 retail inflation target of 5 per cent.

"Assuming that the government implements the 7th Pay commission recommendations by the second quarter of 2016-17, CPI inflation could be, on average, 100-150 bps higher than the baseline in 2016-17. Its impact is expected to persist up to 24 months," Governor Raghuram Rajan said in a report released along with the monetary policy document.

The report, however, noted that the pay hike will boost GDP by around 40 bps during the current fiscal. The pay hike impact will also jack up food prices, the report said, adding that "food prices could consequently increase, leading to inflation rising above the baseline by 80-100 bps in 2016-17, even assuming effective government policies relating to food stocks, procurement and minimum support prices".

On achieving the inflation target (6 per cent in January this year), the Governor said inflation has evolved along the projected trajectory and the January 2016 target was met with a marginal undershoot.

"Going forward, CPI inflation is expected to decelerate modestly and remain around 5 per cent in FY17 with small inter-quarter variations," he said, but warned that there are uncertainties surrounding this inflation path emanating from recent unseasonal rains, the likely spatial and temporal distribution of monsoons, the low reservoir levels by historical averages, and the strength of the recent upturn in commodity prices, especially oil.

Persistence of inflation in certain services warrants watching, mainly due to pay hikes, he said, while there will be some offsetting downside pressures stemming from tepid demand in the global economy. But the government's effective supply-side measures keeping a check on food prices, and "the government's commendable commitment to fiscal consolidation" will have a salutary impact on inflation.

On growth, which it has retained at 7.6 percent for this fiscal, the report said, "The uneven recovery in growth in FY16 is likely to strengthen gradually in FY17, assuming normal monsoons, the likely boost to consumption demand from the implementation of the pay commission and OROP, and continuing monetary policy accommodation."

The gross value add growth projection for 2016-17 is retained at 7.6 per cent, "with risks evenly balanced".