Investors in India already have had two major shifts in policy guidance so far in 2011. The first was the federal budget in February that signalled some overdue spending restraint after sharply higher expenditure in the prior three years. The second is the recent RBI policy meeting where the central bank announced a higher-than-expected 50 bps increase in the repo rate. Both signalled a change in guidance and were followed through with some initial actions, with RBI historically enjoying a bit more credibility on its actions than the government in setting its fiscal house in order.

The fiscal deficit target of 4.6% of GDP for FY12 was wishful thinking to start with, and investors will get around to focusing more on its slippage that was likely even before the ink was dry.

RBI?s recent shift is more striking as it was unexpected. However, its own inflation guidance appears to partly compromise its renewed efforts to earn brownie points for fighting inflation. Indian policymakers have been strangely unique until recently in saying that monetary tightening will check inflation without affecting growth, when the very idea of monetary tightening is to affect aggregate demand, which, in turn, moderates growth, hence checking inflation.

RBI has at least corrected that causality, and the government will probably soon follow.

While higher global commodity prices remain a risk to growth and inflation, RBI suggests that it wants to further moderate aggregate demand as that is contributing to higher inflation, even as its own measures are already being effective in moderating demand. Now, investment spending is not rebounding, so that could not be contributing to inflation. Nor is it being affected by inflation?the government?s inaction is the biggest cause of the investment malaise. Recall that investment spending was much stronger in 2006-08, even though inflation was a real concern.

That leaves the bulk of the demand adjustment on consumption and government spending. Consumption will likely be more resilient, but a quicker and more complete fuel price adjustment that shrinks the subsidy bill and the government?s fiscal deficit will be much more effective in moderating aggregate demand, and hopefully also limit the magnitude of rate increases needed. Of course, the government should have gone in for a much earlier slowdown in its spending.

No central bank worth its salt will ever suggest that inflation in its economy is on a new higher normal, as that would be admitting defeat. RBI is no different. But outcomes speak louder than words and actions. Few appear to realise that the actual WPI inflation (an inappropriate measure to set interest rate policy uniquely practised in India, but that is a different issue) has been consistently overshooting RBI?s forecast in the last several years.

With the exception of the disinflationary spiral in FY09, following the global credit crisis (recall that RBI was still worried about inflation in its October 2008 policy when all hell had already broken loose globally), the outcome for end-March has been higher than the guidance it has offered in the prior year. While the overshooting averaged 2 full percentage points in FY07 and FY08, the magnitude jumped to average just shy of 5 percentage points in FY10 and FY11. Frankly, it is hard to imagine why inflation in the current fiscal year will not overshoot.

To be fair, the WPI inflation trajectory is affected by uncertainty over the monsoons and the government?s decision about increasing local fuel prices. These are the same risks that market economists have to deal with as well and the track record there is not any better. But, as the central bank, RBI has the final call of deciding an appropriate inflation measure so as to focus on things that it can control. Indeed, just to get back on track, RBI will have to meet its forecast for some time.

In the final tally, despite all the rhetoric of a more assertive and hawkish RBI that will fix the current high inflation even at the expense of near-term growth, the central bank?s forecast of WPI inflation of 6% (with upward bias) for March 2012 is the highest in at least seven years.

Go figure.

The author is senior economist at CLSA, Singapore. These are his personal views