Apparently this is bad. I did not know this until I was about 22, and my friend Helen pointed it out, but not very clearly. I must have used the word "she" to refer to her when she was within hearing distance, and she said to me, "'She' is the cat." I probably stared at her blankly and she said that when she was a kid, her father would chide her and her siblings for referring to her mother as 'she', specifically if the mother was present in the room. He would say, "'She' is the cat; that's your mother you're talking about."
And if you think about it, he violates the rule in his reprimand by calling his wife 'that'. Whatever.
I told Helen I was sorry to hear she was beaten as a child and blithely lived my life little changed with respect to this usage until I started hearing more and more people speak about it. (About four or five years later when her brother Tom started working where I do, I asked him about this. He said he remembered something about this but wasn't sure).
In any event, it seems that it is rude to refer to anyone present in the room with a pronoun. So if Cindy were in the room and I told Mark that "Cindy just went to Cindy's house to get Cindy's camera bag," in stead of "Cindy went to her house to get her camera bag," I would sound dorky but I would be following the rule.
If you are reading this and YOU have experience with this odd socio-linguistic phenomenon, please post something about it here.