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This is an edited, translated version of an article that originally appeared on September 8, 2022.
The European Central Bank, or the ECB, raised interest rates by a record-high 75 basis points, or 0.75%, last week.
In a statement, representatives for the bank said that it wanted to "ensure the timely return of inflation to the ECB's 2% medium-term target."
Representatives added that it made the decision, "and expects to raise interest rates further, because inflation remains far too high and is likely to stay above target for an extended period."
The move comes on the back of a 0.5% percentage increase in July, which was the first time the ECB had increased rates in 11 years. Despite this, inflation in the eurozone rose to a record 9.1% in August.
The interest rate on the main refinancing operations — which banks pay when borrowing for one week from the ECB — has been raised to 1.25%.
The interest rate on the marginal lending facility — the rate banks pay when borrowing overnight from the ECB — is now 1.5%.
The deposit rate, which is the rate that banks can deposit money with the ECB overnight, now stands at 0.75%.
"If you raise interest rates today, inflation doesn't automatically go down tomorrow or the next day," Tobias Basse, an analyst at Norddeutsche Landesbank, told Insider.
When the interest banks pay on central-bank loans rises, they pass this on to their customers and raise the interest rates on loans: investing becomes more expensive, he continued, adding that this dampens demand and thus prices.
"Prices are likely to react to the interest rate changes with a time lag of three to six months at best," Basse said.
But the expectation of inflation is itself important for price developments. If they expect prices to rise, workers in turn will demand higher wages, which can drive up prices, potentially prompting a wage-price spiral.
"If the central banks succeed in ensuring that expectations of high inflation do not become entrenched, this will lead to a noticeable decline in inflation in the medium term," Basse said.
Previous interest rate rises have brought savers one key thing: the end of negative interest rates. But because inflation has risen sharply, real interest rates — those that account for the impact of inflation – have dipped even further below 0%.
This gap is likely to close only slowly. Many experts expect savings interest rates to initially develop in parallel with key interest rates.
An interest rate hike of 0.75% was mostly priced into the financial markets.
Rising interest rates are putting pressure on share prices for two reasons. First, other interest-bearing investments with lower risks are becoming more attractive.
This means that less money is flowing into the stock market — especially into riskier stocks like tech. Second, higher interest rates dampen the economy and thus the business opportunities of listed companies.
Low interest rates, the tepid economy in Europe, and the energy crisis have weakened the euro, with the currency recently falling below $0.99 for the first time in 20 years.
With an interest-rate rise, the euro could strengthen, as the higher interest rates mean that more money will flow into the eurozone.
However, the interest-rate rise is also likely to be largely priced-in on the foreign-exchange market, but the expectation of further rises to come could be crucial in determining how the currency moves.
Higher interest rates make loans for investments more expensive and make saving more attractive.
"Monetary policy aims to limit growth to help bring inflation back to 2%," Jochen Stanzl, an analyst at CMC Markets, said.
But the current situation is unusual: Normally, central banks dampen a fast-growing economy with interest-rate rises. Currently, however, many countries in the eurozone are on the brink of recession.
Raising interest rates in a downturn carries high risks.
"This is very likely to turn a soft landing for Europe's economy into a real full-blown slowdown," Stanzl said.
Basse added that "central banks face a dilemma: they have to combat the high inflation expectations of private households. At the same time, the interest-rate hikes currently being discussed by the Fed in the US — up to as much as 4% — would severely dampen economic development, which in turn would threaten a recession.
"This danger is real, at least in the US."