Switzerland is now flirting with deflation, causing a dilemma for its central bank

Key Points

• Switzerland could be at risk of slipping into deflationary territory next year as a stronger Swiss franc beleaguers policymakers' efforts to get a handle on price growth.
• Analysts say it looks increasingly likely that the Swiss National Bank will have to use foreign currency intervention to prevent the country from slipping into a deflationary environment.
• "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," Adrian Prettejohn, Europe economist at Capital Economics, said.

Switzerland could be at risk of slipping into deflationary territory next year, as a stronger Swiss franc beleaguers policymakers' efforts to get a handle on price growth.

The Swiss National Bank cut interest rates for the third time this year in September, citing the strength of the safe-haven currency as a key driver of the country's falling inflation rate, alongside lower oil and electricity prices.

The central bank also revised down its forecasts, putting the average annual inflation rate for 2024 at 1.2% from 1.3%, while projecting price increases will grow by 0.6% in 2025, compared with a previous outlook of 1.1%.

Outgoing SNB chairman Thomas Jordan said at the time that the strong franc had had a "material impact" on the revisions, but downplayed the risk of deflation, noting that the forecasts remained "within the range of price stability." He added that policymakers remain poised to adjust monetary policy further to get a handle on inflation.

But analysts say it now looks increasingly likely that the bank will have to lean on foreign currency intervention to prevent the country from slipping into a deflationary environment.

Our forecast is for inflation to fall as low as 0.1% ... it would not take much to push that below zero
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," Adrian Prettejohn, Europe economist at Capital Economics, told CNBC by email on Monday.

Foreign exchange (FX) interventions take place when a bank buys or sells its currency in the FX market to raise or lower its value against another currency. Such measures can reduce price distortions, which can impact inflation, particularly in trade-heavy economies.

"We would not rule out the possibility of interventions in the FX markets in periods of sharp appreciation pressure," Sophie Altermatt, Julius Baer economist, told CNBC by email.

Switzerland's low inflation case

The Swiss franc has rallied over recent months and is currently hovering near record highs, as investors have piled into the safe-haven asset amid market volatility and the unwinding of the yen carry trade.

As of Wednesday, EUR/CHF was seen trading around 0.9414 and USD/CHF at 0.8669.

Swiss inflation has meanwhile continued to fall.

Switzerland was an outlier among major economies in the double-digit inflation spiral of recent years, with prices rises in the small European nation topping out at a 29-year-high of 3.5% in August 2022. In March, with inflation at 1.2%, the SNB become the first major Western central bank to cut interest rates.

Inflation declined further in September, recording an annual rise of 0.8%, compared to 1.1% in August.

Capital Economics said in a note last week that it now sees inflation in Switzerland falling to 0.3% in 2025, down from its previous estimate of 0.8%, due to the strength of the franc and lower oil and housing costs. That figure could turn negative in certain months, Prettejohn noted Monday.

"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," he said, describing deflation as a "real possibility."

Risks to the safe haven currency

SNB's Jordan signalled to CNBC last month that currency intervention could be used alongside interest rates "if necessary" to get a handle on prices, but did not commit to a timeline.

The bank is currently seen holding rates steady at its next meeting in December, before cutting by 25 basis points to take the terminal rate to 0.75% in the first quarter of 2025, according to a Reuters poll of economists.

Maxime Botteron, economist and chief investment officer at UBS Global Wealth Management, said it may be at that point that the bank turns to currency intervention.

"Once the policy rate tool is exhausted, then you will typically see the SNB intervening in the FX market if more easing is needed," Botteron told CNBC's "Squawk Box Europe" last month.

"FX intervention may become a more appropriate policy tool as the SNB's policy rate nears its effective lower bound, in our view," BNP Paribas added in a note last month.

Still, Botteron said that the appreciation of the Swiss franc was in itself not yet a cause for concern, with the safe-haven currency's pace of appreciation still trending well below the peaks of 2011 and 2015.

"We are not in an environment where we should we worried about [the] overvaluation of the Swiss franc," Botteron said.

"We see some downside risk to inflation next year," he continued. "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," he added.

The SNB will meet on Dec. 12 to provide its latest monetary policy decision.