(Adds governor, details, more background)
By Luiza Ilie
BUCHAREST, Feb 7 (Reuters) - Romania's central bank left its benchmark interest rate unchanged on Tuesday at a record low of 1.75 percent, as expected, maintaining a cautious stance after street protests forced the government to ditch a contested decree.
Consumer prices fell by an expected 0.5 percent on the year in December and have been in negative territory throughout 2016 following cuts in value-added tax and lower energy prices. The central bank targets inflation at 1.5 to 3.5 percent.
Governor Mugur Isarescu said inflation was expected to return to positive territory in the first quarter, but that a new end-2017 forecast that will be revealed on Thursday will now fall below an initial estimate of 2.1 percent.
"Inflation will re-enter the target band towards the end of 2017 and at the start of 2018 will reach the upper half of this range," Isarescu told a news conference.
Asked about the possible impact of the mass street protests that have shaken the leftist=led government over the past week, Isarescu said: "Instability and political tensions cannot help. To quote one of today's (newspaper) headlines, the economy is minding its business but we must not test it."
At least half a million people joined street protests around Romania, outraged by a late-night decree adopted on Feb. 1 that aimed to decriminalise some graft offences. The government rescinded the decree on Sunday.
Isarescu said the biggest internal risks to Romania's financial stability stemmed from the government's fiscal and income policies.
Earlier on Tuesday Romania's parliament approved a 2017 budget plan with increased social spending. It set the deficit at 3 percent of national output, the EU's ceiling, and projected economic growth of 5.2 percent.
Isarescu said the plan's revenue estimates were ambitious, while spending plans were "rather optimistic".
Analysts had forecast no change in rates on Tuesday, but most expect increases towards the end of 2017. The next central bank meeting is on April 5.
The bank has signalled that it may first shift monetary policy not via its key rate but by narrowing the corridor between its lending and deposit facilities, which would in turn affect interbank rates.
ING Romania chief economist Ciprian Dascalu said the bank could begin narrowing the corridor as early as the next rate-setting meeting.
Isarescu said external risks to inflation stemmed, among other things, from the diverging monetary policies of the world's largest central banks and Britain's exit from the European Union.
Romania's leu currency, driven by the political uncertainty to 7-month lows last week, extended its recovery on Tuesday as investors refocused on Romania's healthy growth outlook.
The leu was up 0.3 percent on the day against the euro, bid at 4.4909 at 1435 GMT, supported by comments made by Romania's president in parliament and by a constitutional court decision to reject a Swiss franc loan conversion bill. (Editing by Gareth Jones)