Euro area activity rebounded strongly in the second quarter of this year and looks set to also have been strong in the third quarter, supported by a marked recovery in domestic demand on the back of the success of vaccination campaigns and substantial monetary and fiscal policy support. While there is still uncertainty about how the pandemic will develop from here, we see the risks surrounding the euro area growth outlook as being broadly balanced over the medium term. The downside risks are related both to the pandemic and supply bottlenecks becoming more persistent than is currently expected. However, upside risks could also materialise from higher confidence effects and further spending by consumers. Inflation has increased markedly since the beginning of this year and we expect it to rise further this autumn. We continue to view this upswing as being largely driven by temporary factors, especially the strong recovery in oil prices from the sharp drop in spring 2020, the reversal of the temporary VAT reduction in Germany, and cost pressures arising from temporary shortages of materials and equipment. The impact of these factors should fade out of annual rates of price changes in the course of next year, dampening annual inflation. Our baseline scenario foresees inflation gradually increasing thereafter, but remaining below our 2% target over the medium term. Inflation could prove weaker than foreseen if a renewed tightening of pandemic-related restrictions were to affect economic activity.

While there are certainly grounds for limiting exchange rate fluctuations to prevent temporary misalignments, targeting exchange rates is likely to be counterproductive in the long-run. Doing so requires policymakers to choose a level of the exchange rate to stabilize around. This can be very difficult to implement in practice, not least because the target would change over time as fundamentals evolve. Importantly, there is little that monetary policy can do to influence real exchange rates in the long run. Past attempts to give the exchange rate more weight in monetary policy decisions tended to generate more interest rate volatility, with little lasting effect on the real exchange rate. Here, I should note that emerging markets are generally better placed than in past cycles to withstand capital flow volatility. Key areas where progress has been made include: more flexible exchange rates, clearer monetary policy frameworks, larger foreign reserve cushions, generally moderate external debt levels, improved fiscal discipline, and better capitalized banking systems, supported by stronger supervisory and regulatory frameworks. Moreover, the general shift away from debt-based finance towards equity and foreign direct investment, which together now account for two-thirds of emerging market financing, is significant from a stability perspective. Nevertheless, I want to stress that there is an enormous amount of heterogeneity among emerging market economies. The underlying strengths and weaknesses in terms of institutions and economic capabilities of Thailand and Brazil, for example, are very different. The destinies of emerging markets are not tightly bounded to each other like General Cao Cao’s battleships.