The Reserve Bank of India painted a gloomy picture of the country's economy on Monday, citing both a sluggish growth outlook and persistent inflation, a day before it is expected to hold interest rates steady for the second time in two months.
The RBI also maintained pressure on the deficit-strapped government to cut subsidies and invest more to stimulate growth.
"The near-term outlook on inflation continues to be marked by a number of upside risks, despite the significant slowdown in growth," the RBI said in its quarterly report on macroeconomic and monetary developments.
"The outlook for growth looks weak and substantially affected by global headwinds, inflation, and policy uncertainty," it said.
An RBI survey of economists forecast the Indian economy will grow at 6.5 percent in the fiscal year that began on April 1, from the 7.2 percent forecast in a survey three months ago.
Headline wholesale price index inflation remained above 7 percent in June, with the consumer price index sticky at 10 percent even as growth slowed to a nine year low of 5.3 percent in the March quarter in Asia's third-largest economy.
On Monday, the RBI indicated it had little room to maneuver.
"Fiscal and monetary space to stimulate the economy remain limited in the presence of an already large fiscal deficit and persistent inflation," the report said.
A Reuters poll last week showed 19 of 20 economists do not expect the RBI to bring down its key repo rate from its current 8 percent after a steeper-than-expected 50 basis point cut in April.
The RBI kept rates on hold in June, explaining it had "frontloaded" rate cutting in April and arguing that high interest rates were not the key reason for slowing growth.
Hopes among investors that the RBI might ease rates on Tuesday have been eroded by a rise in food prices, caused by weaker-than-normal summer monsoon rains, as well as receding expectations that the government will soon cut subsidies on diesel, a key driver of its fiscal deficit.
"Fiscal space needs to be created by curtailing subsidies and significantly boosting government capital expenditures to provide an investment stimulus to the economy," the RBI said.
It said the government should clear infrastructure bottlenecks and remove constraints on foreign direct investment in order to bolster the investment climate. India has been considering easing foreign investment rules in the supermarket and airline sectors.
India's fiscal deficit for the year that ended in March was 5.76 percent of GDP, and many economists say its aim to trim that to 5.1 percent in the current fiscal year looks optimistic.