Imagine you had fallen asleep a year ago and had just woken up, wanting to reacquaint yourself with the world economy. You would get quite a shock.

Just as it was last summer, global growth is strong. The International Monetary Fund expects expansion of 4.1 per cent this year, compared with an average of 3.4 per cent since 1990.

Inflation is the real surprise. Last July the IMF predicted price pressures would remain "generally well-contained despite strong global growth"; today, inflation in advanced economies is at its highest rate since 1992, rising from 2.2 per cent in 2007 to an IMF projection of 3.4 per cent in 2008. For emerging and developing countries inflation is up from 6.4 per cent to 9.1 per cent, the fastest since 1999.

On seeing the data alongside high food and oil prices - still way above their levels last year, in spite of recent falls - your immediate historical parallel would not be one that is often drawn, with the early 1930s; it would be the inflation followed by stagnation of the 1970s. The IMF's forecast of a slowing world economy in the second half of 2008 is entirely consistent with high commodity prices.

You would not have expected US interest rates to have been cut from 5.25 per cent to 2 per cent; for real interest rates across Asia to be negative and for European interest rates to be more or less the same as a year ago.

So, a year into the big freeze in financial markets and the world economy bears all the hallmarks of overheating, not another Great Depression. Yet that global truth is almost entirely lost on policymakers, many of whom talk about rising energy and food prices as if they had nothing to do with them.

Ben Bernanke, the Federal Reserve chairman, told Congress in July that domestic problems had been "compounded by rapid increases in the prices of energy and other commodities". Jean-Claude Trichet, president of the European Central Bank, complains that the "worrying level of inflation rates results largely from sharp increases in energy and food prices at the global level". Mervyn King, the Bank of England governor, meanwhile insists that rising UK inflation is the fault of "developments in the global balance of demand and supply for food and energy".

Such sentiments are shared in the developing world. Speaking after the annual meeting of the Bank for International Settlements, Zhou Xiaochuan, governor of the People's Bank of China, said: "We know the international price of energy and other commodities, they add additional pressure to inflation in China."

Each statement is accurate taken in isolation; collectively, they are nonsense. The world cannot import inflation. If every country pursues policies to maintain demand and "look through" a temporary rise in commodities, global demand is likely to continue to exceed supply for some time.

As Mr King, when he was thinking more globally, told British parliamentarians in June: "The biggest challenge for the world economy as a whole is not the oil price as such - I think there are mechanisms that will lead eventually to an equilibrating between demand and supply - but it is trying to ensure a monetary policy framework for the world as a whole that does not build into it an excess inflationary impetus." The implication was that the world, but not individual countries, might need the ravages of a credit crisis to slow the rate of global expansion enough to keep inflation under control.

So how did the global economy get into such a mess? There is little doubt that the immediate cause of both the commodities price boom and the credit crisis has been low global interest rates.

Cheap money encouraged rapid growth: between 2004 and 2007, the world economy expanded at its fastest rate in 30 years. It encouraged investors to search for higher yields and buy into new asset classes. The new money led to easier credit conditions, extending cash to US borrowers with patchy credit histories who previously had been unable to buy property, cars and durable goods.

US expenditure on imports maintained the rapid expansion of production in Asia and in oil exporters, aided by extremely competitive exchange rates and rigid currency ties. Meanwhile, consumption restraint kept capital flowing from poor to rich countries and stopped the world economy overheating.

For a long time, this appeared to be a virtuous circle, dubbed "Bretton Woods II" in reference to the pegged exchange rate system that operated from the end of the second world war until the early 1970s. Most economists thought the 21st century version would prove as unsustainable as its predecessor, relying as it did on ever-greater US trade deficits. Concerns grew over "global imbalances" and predictions abounded that they would finally unwind with a collapse in confidence in the US dollar.

None of the forecasts of doom materialised. Instead, the crucial rupture came when rising defaults among US subprime mortgage-holders undermined the rationale for the expansion of credit, forcing the contraction of financial balance sheets that has stalked the financial world ever since.

Over the past year, meanwhile, rapid global economic growth finally hit capacity constraints. Demand for commodities and food continued to exceed supply, forcing prices sharply higher, raising inflation and further undermining spending power in advanced economies.

Most economists were sanguine when the credit crisis broke last August. A crisis in subprime mortgages would not affect the vast bulk of lending to households and companies, they argued, and the stock of subprime debt was too small to affect the health of the financial sector. Central bankers welcomed what they saw as a desirable repricing of risk.

But as August wore on and the crisis deepened, economic views as well as policy began to change. The European Central Bank and the Federal Reserve offered emergency liquidity support for financial institutions. By mid-September, the Fed had cut its policy rates by half a percentage point and the ECB had postponed a rise it had previously pencilled in. Ever since, the US has been easing monetary and fiscal policy.

Each central bank has a delicate balancing act to perform. Let high inflation become normal in an economy and a wage-price spiral can develop, requiring much more brutal policy action in the future. But allow the economy to weaken too far and a vicious circle could develop, with more bank defaults leading to further downward pressure on growth.

The conditions are different in every country. As the Bank for International Settlements, the central bankers' bank, said in its annual report, this should "rule out a 'one size fits all' response".

Gulf, Asian and developing economies are caught between the popular demand for continued rapid growth and the constraint of higher inflation, made all the more damaging by the fact that food and fuel account for a higher proportion of spending in poor countries.

So far, maintaining growth has been the priority. Price rises started in food and energy but have now become widespread, with signs of upward pressure on wages. The Asian Development Bank warned last month of the danger of "repeating the mistakes industrialised nations made prior to the Great Inflation of the 1970s".

Hardest to deal with is the collective action problem: the right policies for individual economies do not necessarily add up to the right policies for the world. This is where the International Monetary Fund should step forward to break the deadlock. But the IMF's impotence in securing policy changes from countries that have no need of its finance has been laid bare over the past year.

In its recently updated World Economic Outlook, it noted how the US, the eurozone, Japan, China and Saudi Arabia had agreed "mutually consistent" policies in 2006 to squeeze global imbalances and make the global economy a safer place. Last month, John Lipsky, the Fund's number two, insisted he still viewed the policy proposals to be relevant. But he was forced to concede that there has been little progress in implementing them.

China's currency has appreciated against the dollar but not by much on a trade-weighted basis. The US has abandoned budgetary consolidation in favour of stimulus packages. Saudi Arabia's plans to spend more of its oil revenues on its population have come unstuck as energy prices have risen. Europe and Japan are peripheral to the action and have made little impact on imbalances either way.

Mr Lipsky was forced to conclude: "While the dollar depreciation is helping to reduce the US current account deficit, it has not been sufficient to alleviate imbalances and risks. Rather, new misalignments may be emerging and risks may be shifting."

So what next for the world economy? If consensus forecasts are to be believed, everything will be fine. The world economy will slow just enough to ensure that the inflationary period is temporary; financial markets will gradually recover; and the world economy will continue to grow at about 4.5 per cent a year indefinitely.

This appears much too rosy and probably suggests a faster sustainable rate of world economic expansion than the evidence of the past few years suggests is plausible. As the BIS annual report concluded: "With inflation a clear and present threat, and with real policy rates in most countries very low by historical standards, a global bias towards monetary tightening would seem appropriate."

Many central bankers certainly think the consensus is too optimistic. In private, dark humour abounds. They are sure they will make a mistake but have no idea in which direction it will be. And everyone wants someone else to take the really tough decisions.

The US and Europe want Asia to tighten policy and revalue currencies to snuff out inflation. Asia, however, insists that its exchange rate policies are its own concern and wants to defend its remarkable growth rates and export-led industries, blaming advanced economies for a home-grown financial crisis. Oil producers hope to be able to ride the energy boom without succumbing either to an inflationary spiral or a sudden worldwide recession, sending oil prices crashing.

For all the disagreements, there is little doubt that the world economy is in trouble, poised between the rock of recession and hard place of overheating. It will take a remarkable resumption in global policy co-ordination and a huge dose of luck to avoid one or the other.

A Fed under pressure is forced to push its mandate to the limit

The US economy remains in limbo: neither pulling away from nor succumbing to pressure from the credit squeeze, falling house values and high oil prices. With only one quarter of negative growth - the final one of 2007 - the jury is still out on whether the US has had or will have a recession. Growth in the first half of this year was weak but positive, boosted by tax rebates, though there are renewed concerns about a double-dip downturn around the turn of the year, writes Krishna Guha.

The absence of a full-blown recession owes much to strong support from trade - which has contributed on average 1.6 per cent to annualised growth in each of the past five quarters - and rapid gains in productivity, which have mitigated the oil shock. But most economists believe the Federal Reserve also deserves credit for navigating some difficult trade-offs between growth and inflation - not perfectly, but without making a big mistake on either front.

When the subprime crisis metastasized into the credit crisis in August 2007, the questions were how big an impact this financial disruption would have on the US economy and what tools should be used to address it. Ben Bernanke resolved that the Fed should accommodate a shift in the private sector's demand for liquidity through enhanced liquidity operations. But implementing this proved difficult. The Fed discovered its liquidity tools were out of date and carried too much stigma to be effective. Tim Geithner, the president of the New York Fed, was forced to improvise an entire new suite of tools, deployed from December onwards.

Mr Bernanke decided rate cuts were also needed, setting the Fed on a different course to the ECB, which did not face a domestic housing slump and falling household wealth. This brought substantial depreciation of the dollar against the euro and some other floating currencies - the Fed had wanted some depreciation but was edgy about the possibility that this could become disorderly.

The US central bank began cutting rates before there was any tangible evidence of a slowdown in the economy. But it did not move fast enough for many in the markets. At its policy meeting in October, the US central bank blundered by signalling that it thought it had done enough. Tensions with the market were aggravated by outspoken comments from hawkish regional Fed presidents.

Towards the end of 2007, Mr Bernanke, his number two Don Kohn, and Mr Geithner pulled more reluctant colleagues along with further rate cuts. But they moved cautiously, concerned about the link between rate cuts, the dollar, rising oil and inflation. Then a sudden weakening in economic data at the turn of the year suggested the Fed had fallen behind the curve. Mr Bernanke took control and cut rates by 125 basis points in eight days in late January 2008 - with another 75 point cut in March. Nothing like this had happened in 18 years of Alan Greenspan's Fed chairmanship.

The Fed cited two reasons for this dramatic action: the need to buy insurance against the "tail risk" of a very bad outcome on growth, and to offset the widening in risk spreads. It never clarified the relative weight of these factors - which haunts the Fed today, as the debate turns to the conditions for raising rates again.

As the financial markets appeared poised for meltdown with the crisis at Bear Stearns in mid-March, the Fed acted decisively in partnership with the Treasury to support a takeover and ensure other investment banks had access to emergency cash - creating in the process a serious moral hazard problem for the future.

Since then, as headline inflation has risen to 5 per cent, putting pressure on core prices and unsettling inflation expectations, the Fed has begun to worry more about inflation risk. Inside the Fed there is a consensus that the next move in rates is up; the argument is over when and how fast. Fresh concerns about growth could keep the Fed on hold for a while, particularly if it turns out that oil really has peaked. But only if inflation expectations edge lower in response to economic weakness and lower oil. Looking ahead, Fed officials think the moment could come when they can decouple liquidity and interest rate tools, using liquidity tools to support a fragile financial system while recalibrating rates to address macroeconomic forces.

In a series of speeches, Paul Volcker, the former Fed chairman, expressed concern that too much is being asked of the Fed, which is operating at the limit of its mandate and of what its tools can achieve. This sentiment is shared within the current Fed. Policymakers fear the market exaggerates the Fed's power to shape economic trade-offs as opposed to choose between them. Many Fed officials feel the current policy mix is wrong - that the government should do more, allowing them to do less. But they are sceptical of the merits of a second stimulus, and feel if public funds are deployed, they should be targeted at housing and bank capital instead.