The central bank of Switzerland is facing a dilemma due to the country's potential deflation.

• Policymakers in Switzerland may struggle to control inflation next year due to a stronger Swiss franc, which could lead to deflationary conditions.
• It seems increasingly probable that the Swiss National Bank will resort to foreign currency intervention to prevent the country from falling into a deflationary spiral.
• According to Adrian Prettejohn, Europe economist at Capital Economics, our forecast predicts inflation to drop as low as 0.1% in certain months, which means it wouldn't take much to push it below zero.

Policymakers in Switzerland may struggle to control inflation next year due to a stronger Swiss franc, which could lead to deflationary conditions.

In September, the Swiss National Bank reduced interest rates for the third time in 2021, stating that the strong Swiss franc, as well as lower oil and electricity prices, were the primary factors contributing to the country's declining inflation rate.

The central bank revised its inflation forecasts, predicting an average annual rate of 1.2% in 2024, down from 1.3%, and a projected growth of 0.6% in price increases for 2025, compared to a previous outlook of 1.1%.

At the time, SNB chairman Thomas Jordan stated that the strong franc had a significant impact on revisions, but he minimized the risk of deflation, stating that the forecasts remained within the range of price stability. He also mentioned that policymakers were prepared to make additional adjustments to monetary policy to control inflation.

It is becoming increasingly likely that the bank will need to use foreign currency intervention to prevent the country from experiencing deflation.

While there is room for interest rate cuts, it may be more prudent for the SNB to directly influence the franc's value through FX interventions, as doing so could push Switzerland into deflation territory, according to Adrian Prettejohn, Europe economist at Capital Economics, in an email to CNBC on Monday.

Banks engage in FX interventions by purchasing or selling their currency in the FX market to alter its value relative to another currency. This can mitigate price disparities, which can have a bearing on inflation, particularly in economies that heavily rely on trade.

Sophie Altermatt, Julius Baer economist, stated in an email to CNBC that they would not exclude the possibility of interventions in the FX markets during times of intense appreciation pressure.

Switzerland's low inflation case

Recently, the Swiss franc has strengthened and is close to its all-time highs, as investors have sought refuge in the safe-haven currency amid market turbulence and the unraveling of the yen carry trade.

On Wednesday, EUR/CHF was trading at approximately 0.9414, while USD/CHF was trading at about 0.8669.

Swiss inflation has meanwhile continued to fall.

In August 2022, Switzerland experienced a 29-year-high inflation rate of 3.5%, despite being an outlier among major economies in the recent double-digit inflation spiral. In March, the SNB became the first major Western central bank to cut interest rates, with inflation at 1.2%.

In September, the annual inflation rate decreased to 0.8%, down from 1.1% in August.

Capital Economics revised its inflation forecast for Switzerland, predicting a decrease from 0.8% to 0.3% in 2025. This change is attributed to the strength of the franc and lower oil and housing costs. Prettejohn added that the figure could even turn negative in certain months.

"He stated that deflation is a "real possibility" as our forecast predicts inflation to fall as low as 0.1% in some months, meaning it would not take much to push it below zero."

Risks to the safe haven currency

Last month, SNB's Jordan stated that currency intervention could be used in conjunction with interest rates to control prices, but did not specify a timeframe.

According to a Reuters poll of economists, the bank is expected to keep rates steady at its next meeting in December before cutting by 25 basis points to reach a terminal rate of 0.75% in the first quarter of 2025.

UBS Global Wealth Management's chief investment officer and economist, Maxime Botteron, stated that the bank may resort to currency intervention at that point.

If the policy rate tool is depleted, the SNB may intervene in the FX market to provide more easing, as Botteron stated on CNBC's "Squawk Box Europe" last month.

In our view, as the SNB's policy rate approaches its effective lower limit, FX intervention may become a more suitable policy tool, BNP Paribas stated in a note last month.

Botteron stated that the Swiss franc's appreciation was not yet a cause for concern, as its pace of appreciation was still below the peaks of 2011 and 2015.

Botteron stated that we should not be concerned about the overvaluation of the Swiss franc in the current environment.

Although there is a possibility of inflation next year, as long as there is no significant appreciation, the risk of deflation requiring an aggressive easing of monetary policy is unlikely at this time, he stated.

The SNB will make its latest monetary policy decision on Dec. 12.