Financial market investors demand an extra return, known as the Inflation Risk Premium (IRP), to compensate them for the risk that unexpected inflation will erode the real value of future bond payments.

Sovereign bond yields are split into three distinct components to analyze market sentiment:

Nominal Bond Yield = Expected Real Interest Rate + Expected Inflation Rate + Inflation Risk Premium

When a central bank’s commitment to its inflation target loses credibility, the IRP component spikes, causing the yield curve to steepen. This increase drives up long-term borrowing costs for corporations and home buyers, independent of changes in short-term policy interest rates.