A lot is said about inflation being a global problem today. But when you glance at the front page of the Bank of England website, they report CPI inflation of 3% as compared with an inflation target of 2%. This is not so bad when compared with the 8% inflation that we see in India and China. The Economist has a good article interpreting the bad inflation that has sprung up in third world countries. Their main argument is that these countries are making the same mistakes in monetary policy formulation which gave high inflation in industrial countries in the 1970s. Economists in industrial countries, and then central banks in industrial countries, digested the lessons of these experiences, but this learning did not happen in (say) India.
One simple way to see how monetary policy has gone wrong is the `Taylor principle'. When there is a 100 bps rise in inflationary expectations, if the policy rate does not rise by atleast 100 bps, then the real rate goes down. Under such a monetary policy regime, positive inflation shocks are expansionary (and vice versa). Monetary policy is destabilising. This is a key channel through which a central bank which is not primarily focused on inflation ends up exacerbating the business cycle.
To review the recent Indian experience, yoy CPI inflation was 5.5% and WPI inflation was 4% in late 2007. Both have accelerated by 200-300 bps. But the short rate has not budged. In other words, the real rate has gone down by 200-300 bps. This violates the Taylor principle: when combating inflation, you surely do not want the real rate to drop sharply.
You might like to read this on the Taylor Principle.