Swiss deflation fears rise as strong franc tests central bank’s policy options

Switzerland may be edging closer to deflation as the Swiss franc’s strength continues to weigh on policymakers’ efforts to maintain stable prices.

With the franc rallying near record highs, the Swiss National Bank (SNB) is under increasing pressure to counter a deflationary spiral, which, if unaddressed, could harm economic growth and consumption in the export-reliant nation, according to a report by CNBC.

In September, the SNB made its third interest rate cut of the year, attributing Switzerland’s declining inflation to the franc’s continued strength, alongside lower oil and electricity costs.

The bank revised down its inflation forecast for 2024 to 1.2% and further to 0.6% in 2025, noting a shift from its previous estimate of 1.1%.

Thomas Jordan, the SNB’s outgoing chairman, acknowledged the impact of the strong franc on these revisions, but downplayed deflation risks, stating that inflation remained “within the range of price stability.”

However, Jordan added that policymakers were ready to adjust their approach to stabilize inflation if necessary.

Currency intervention likely amid deflationary pressures

Despite the SNB’s rate cuts, analysts predict that Switzerland’s continued franc appreciation could force the central bank to pivot to foreign exchange (FX) intervention if it cannot curb inflation with conventional policy tools.

According to Adrian Prettejohn, Europe economist at Capital Economics,

There is some scope for further interest rate cuts, but given the scope for franc appreciation to push Switzerland into deflation territory, it would make sense for the SNB to directly target the currency’s valuation through FX interventions.

FX interventions involve a central bank actively buying or selling its currency in the market to influence its exchange rate relative to others.

These interventions could help manage inflation, especially for trade-dependent economies like Switzerland, where imported goods account for a large share of consumer prices.

Julius Baer economist Sophie Altermatt echoed Prettejohn’s sentiment, saying that while the SNB might attempt further rate adjustments, FX intervention could become necessary if sharp franc appreciation persists.

Swiss inflation falls as franc rallies

The franc’s appeal has grown significantly over recent months, bolstered by investor demand for safe-haven assets amid global market volatility and the unwinding of the yen carry trade.

This heightened demand has pushed EUR/CHF and USD/CHF to 0.9414 and 0.8669, respectively, approaching historical peaks.

Switzerland’s inflation, meanwhile, has continued its downward trend.

In March, inflation stood at 1.2%, positioning the SNB as the first Western central bank to lower rates.

Inflation eased further to 0.8% in September, down from 1.1% in August.

Capital Economics recently lowered its inflation forecast, projecting it could fall to 0.3% by 2025, down from an earlier estimate of 0.8%.

“Our forecast is for inflation to fall as low as 0.1% in some months, so it would not take much to push that below zero,” Prettejohn said, adding that deflation is now a “real possibility.”

Prospects for further policy adjustments

SNB Chairman Thomas Jordan indicated last month that currency intervention remains an option, though he refrained from committing to a timeline.

According to a Reuters poll, economists expect the SNB to keep rates steady at its upcoming meeting in December before cutting by 25 basis points in early 2025, potentially taking the terminal rate to 0.75%.

At this point, analysts believe the SNB might look toward FX markets for further relief.

UBS economist Maxime Botteron noted that the bank could turn to currency intervention “once the policy rate tool is exhausted.”

“FX intervention may become a more appropriate policy tool as the SNB’s policy rate nears its effective lower bound,” BNP Paribas remarked in a recent note, highlighting the limitations of traditional monetary policy as interest rates approach zero.

The franc’s risks and limited intervention options

While currency intervention could offer temporary respite, the strength of the Swiss franc is not yet a cause for immediate alarm, according to Botteron.

“We are not in an environment where we should be worried about [the] overvaluation of the Swiss franc,” he said, pointing out that the currency’s pace of appreciation is still below previous peaks seen in 2011 and 2015.

Botteron added, “We see some downside risk to inflation next year. But as long as we don’t have a very sharp appreciation, I think that the risk of deflation that would warrant a far more aggressive easing of monetary policy … is quite unlikely at this stage.”

Despite these assurances, analysts remain cautious, noting that a stronger franc could gradually erode price stability.

Swiss policymakers may ultimately need to weigh the benefits of currency intervention against its risks, particularly as the SNB’s policy rate approaches its lower limits.

SNB’s next steps amid December policy review

The SNB’s policy choices will be in the spotlight at its next meeting on December 12, where it will outline its latest inflation and growth projections.

For now, the bank appears to be holding steady, evaluating its limited options in a deflation-prone environment.

However, with the Swiss franc’s strength a significant variable, the SNB may be compelled to act more decisively to stabilize the economy.

As Switzerland grapples with the potential for deflation, its central bank faces a tough balancing act.

While the SNB’s past FX interventions have shown mixed results, the rising risks of deflation could prompt a fresh round of measures aimed at keeping the franc in check and inflation in positive territory.

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