Prices and Inflation
Economists call a general rise in prices inflation. Inflation is often attributed to an "overheated" economy—that is, an economy that is consuming beyond its capacity to produce. When this happens, buyers bid up the price for goods and services and producers are only willing to increase output if the prices buyers are willing to pay are higher. Banks, especially the Federal Reserve, despise inflation because it erodes the value of their primary assets–currency. As such, the Federal Reserve has a mandate to keep inflation in check. Hence, it is little wonder that economists track inflation closely. Increasing inflation is usually met with a concerted Federal Reserve effort to slow the pace of economic growth. However, certain prices are more important than others. More specifically, the price of energy is a significant component of the standard measure of inflation, called the Consumer Price Index (CPI). However, energy prices are subject to wide swings that have nothing to do with the general pace of economic growth. Hence, economist discount the role of energy prices in the CPI measures. Similarly, but to a lower degree is food prices. The remaining components of the CPI, or core CPI is then the most watched measure of prices.
The graph below shows the spread between the U.S. 10-year fixed treasuries and the U.S. 10-year inflation-adjusted treasuries. The difference largely reflects the risks that investors place on inflation. As inflation reduces the spending power of dollars, when lenders (bond buyers) expect inflation to rise, they insist on earning higher rates of interest to make up for the lower future spending power of the returned payments. When we see the gap between the blue and red line widen, we expect inflation to increase over the next ten years.