Swiss central bank ready to act 'immediately' as deflation risks resurface

By Alice Baghdjian

ZURICH (Reuters) - Switzerland's central bank vowed to vigorously defend a three-year-old cap on the Swiss franc which has come under pressure from a recent appreciation of the currency, but it stopped short of announcing concrete new measures for now.

In a statement in which it warned of renewed risks of deflation and slower growth, the Swiss National Bank (SNB) said it stood ready to make unlimited currency interventions and would resort to additional steps "immediately" if needed to defend the 1.20 per euro cap.

However the tougher rhetoric failed to weaken the Swiss franc, which rose to a one-week high after the announcement - a signal that the bank may ultimately be forced into further, costlier measures such as currency intervention or moving to negative interest rates.

Both options are fraught. Aggressive policy interventions would swell already sizeable foreign exchange reserves and are seen as risky in the long-term. Negative rates could prove costly for Switzerland's banks.

"The SNB is caught in a situation where it can't do much else than threaten further currency interventions and negative interest rates. The SNB may find both alternatives unappealing, but its hands are effectively tied," said Cornelia Luchsinger at Zuercher Kantonalbank.

The franc was slightly stronger at 1.2071 by 1410 GMT (03:10 p.m. BST) after the bank disappointed market players who had expected it to opt for negative rates on Thursday. The currency is near a two-year high versus the euro.

The European Central Bank's unexpected interest rate cut two weeks ago and its new schemes to pump cash into the euro zone economy have intensified pressure on the SNB's minimum exchange rate, introduced in September 2011 when a soaring franc threatened to choke off inflation and hurt the Swiss economy.

Investors are watching to see if the ECB rolls out more aggressive easing to stimulate the euro zone's economy, as this could weaken the euro further in coming months, putting upward pressure on the franc.

Daniel Hartmann at Bantleon Bank said the SNB might prefer imposing fees on franc deposits to pursuing extensive currency interventions because its balance sheet of around 500 billion Swiss francs (326.69 billion pounds) is still bloated from the last round of currency interventions.

But the SNB is likely to wait to see if its verbal interventions do the trick before resorting to any further action, Hartmann predicted.

"Should this not be the case, the SNB won't shrink from introducing negative interest rates," he said.

DEFLATION RISK

In Switzerland, negative rates would probably involve a charge on so-called sight deposits, or the cash commercial banks hold at the SNB.

While the central bank has said it does not rule out the use of negative interest rates, it has stressed it has a broad monetary policy arsenal at hand to combat any franc strength.

The SNB could also intervene in the foreign exchange market, selling francs to cheapen the currency. It used this method in 2012, injecting billions of francs into the market and swelling its foreign currency reserves.

The Swiss National Bank has not intervened in foreign exchange markets since 2012 to defend the cap, its chairman Thomas Jordan told Swiss broadcaster SRF on Thursday.

The residual threat of deflation resurfaced in Thursday's statement as the SNB struck a more downbeat note on the health of the Swiss economy.

"The risk of deflation in Switzerland has increased," the SNB said, adding inflation was set to be lower from mid-2015 onwards.

Switzerland's economy unexpectedly stalled in the second quarter as trade took a hit from stagnation in its main export market Europe and construction spending fell.

"The economic outlook has deteriorated considerably," the SNB said, trimming its growth forecast for this year to just below 1.5 percent, from a previous prediction of near 2 percent, and cutting its inflation forecasts for 2015 and 2016 to 0.2 percent and 0.5 percent, respectively.

(Additional reporting by Katharina Bart, Silke Koltrowitz and Joshua Franklin; Editing by Noah Barkin)