Lek appreciated on average by 2.3 percent against the euro in 2016 and 2017, while it appreciated by around 7 percent during the first half of 2018. Our analyses indicate clearly differing explanations for the pre and post 2018 appreciation. The 2016–2017 lek appreciation has been largely in line with improving fundamentals in the economy. Some of these structural improvements include: Declining current account deficits, on account of improved exports; Increased capital inflows, on account of high FDIs; Reduced financial market risk premia and increased confidence in our financial institutions. 2/3  BIS central bankers' speeches  On the contrary, the rapid appreciation we experienced in 2018 has been largely a FX market driven phenomenon. News of a sudden and sustained influx of foreign currency induced onesided expectations in the FX market. These expectations were reflected in an accelerated supply of foreign currency and delayed demand for it, generating a vicious cycle of continued appreciation. The Bank of Albania did not react upon the real appreciation trend of the past two years. While minor miss-alignments were still present, we assessed the trend was largely driven by improving fundaments. Thus, it allowed us to focus our monetary policy on achieving our 3 percent inflation target. We also did not react upon the recent financial market driven appreciation, in full consistence with our monetary policy and exchange rate regimes. We expected for the market to self-regulate and contain these shocks. However, this did not prove to be the case and the exchange rate appreciation accelerated.

Therefore, our macroeconomic forecasting and monetary policy analysis models prescribe an important role to the exchange rate. Furthermore, in financially euroized economies, such as ours, exchange rate movements tend to have financial stability implications. Rapid depreciation increase NPLs, while prolonged periods of appreciation tend to impose financial risks and encourage further euroization. In designing the appropriate monetary policy response, we have to distinguish between trend movements driven by fundamentals, and short term volatility driven by sporadic factors or market imperfections. Inflation targeting central banks should strive to avoid leaning against trend movements in the exchange rate. As long as these movements are in line with fundamentals, these trends represent structural adjustments that do not move the economy away from equilibrium. On the other hand, short term exchange rate volatility is normal in a fully flexible exchange rate regime. The reaction of central banks should depend on their impact on inflation, which in itself depends on the intensity and duration of such volatility. The stronger the duration and the higher the intensity of the shocks, the bigger would be the expected impact on inflation, the greater the risk of rapid shifts in inflation expectations, and the higher the need for a systematic reaction of monetary policy. 3. Exchange rate movements and the Bank of Albania reaction to them  The above mentioned facts have guided our reaction to the recent appreciation of the exchange rate in Albania. The trend appreciation started around the second half of 2015, but it gathered considerable pace in 2018.