Dec. 23 (Bloomberg) -- India's central bank said fiscal discipline is key to controlling inflation, even as the federal government tries to rein in spending to reduce its budget deficit.

In a report published today, the Reserve Bank of India urged``strict adherence'' to a law that requires the government to cut the government's budget deficit by at least 0.3 percent of gross domestic product every year.

``Fiscal discipline creates enabling conditions for monetary and financial stability,'' said the Report on Currency & Finance released in Mumbai.

A high budget deficit forces the government to print more money to finance it, increasing money supply and fuelling inflation, which in August reached a 3 1/2 year high in India. The country's deficit reached 4.8 percent of gross domestic product last year, the fourth highest after that for Japan, Israel and Cyprus, according to International Monetary Fund statistics for 34 major economies.

The government aims to cut the budget deficit to 4.4 percent of gross domestic product in the year ending March 2005. The federal government on July 5 passed a law requiring the government to eliminate revenue deficit by March 2008, meaning that it can only borrow to fund capital spending thereafter.

India's inflation rate reached 8.74 percent in the week ended Aug. 28, the highest since February 2001, as rising oil prices drove up costs of food, raw materials and manufactured goods.

Indian Finance Minister P. Chidambaram said this month the government wants to slow inflation to below 3 percent and sustain economic growth at between 7 percent and 8 percent.

The government also needs to curb borrowings by state governments that are hindering its efforts to lower the deficit, Standard & Poor's analyst Ping Chew said in an interview this week.

Short-Term Rates

``Right now, the greater fiscal pressure is coming from the states,'' Chew said.

The combined debt of India's federal and state governments may be about 80 percent of GDP in the financial year ending March, Chew wrote in an August report. That compares with 63 percent for just the federal government.

In its report, the Reserve Bank said central banks worldwide are increasingly moving away from targeting one economic indicator to decide monetary policy and prefer to monitor a range of indicators that help them achieve their objectives.

Short-term interest rates have become a significant instrument of signaling monetary policy changes, the central bank said.

The Reserve Bank, in its last monetary policy announcement on Oct. 26, kept its bank rate, which is its signal for medium- term rates, unchanged at a 31-year low of 6 percent. Instead, the bank raised its overnight reverse repurchase rate for the first time in four years to 4.75 percent from 4.5 percent.

To contact the reporter on this story: Ramya Venugopal in Mumbai rvenugopal@bloomberg.net

Last Updated: December 23, 2004 06:32 EST