The Swiss National Bank shocked foreign exchange markets by setting a minimum exchange rate target of 1.20 francs to the euro Tuesday, knocking back a currency rally which has threatened its economy with recession.
Using some of the strongest language by a central bank in the modern era, the SNB said it would buy other currencies in unlimited quantities and use all means within its power to hold to the target.
The move immediately knocked around 8 percent off the value of the franc, which has soared by a third since the collapse of Lehman Brothers in 2008 as investors used it as a safe haven from the euro zone's debt crisis and stock market turmoil.
The current massive overvaluation of the Swiss franc poses an acute threat to the Swiss economy and carries the risk of a deflationary development, the SNB said in a statement.
The SNB will enforce this minimum rate with the utmost determination and is prepared to buy foreign currency in unlimited quantities.
The move prompted speculation that Japan might follow suit to cap the rising yen, which is also regarded as a safe haven and whose rise could derail a recovery from the March earthquake and tsunami that tipped the country into recession.
Japan ... will probably bring up the strong yen as a topic at the G7 meeting this weekend, said Koichi Haji, chief economist at the NLI research institute in Tokyo. It will try to seek understanding from G7 counterparts to intervene unilaterally.
The SNB, which holds its quarterly monetary policy review on Sep. 15, added that even at a rate of 1.20 to the euro, the franc was still high and should continue to weaken over time.
If the economic outlook and deflationary risks so require, the SNB will take further measures, it said.
The SNB has warned that economic growth -- still a healthy 2.3 percent in the second quarter -- is set to slow sharply in the coming months as the strong franc makes Swiss exports -- from luxury watches to drugs -- prohibitively expensive.
The franc nearly touched parity with the euro Aug. 9. It fell 8.5 percent against the euro after the announcement to 1.203 francs at 0821 GMT and also dipped almost 8 percent against the dollar to 0.8483.
That was the single largest foreign exchange move I have ever seen, said World First chief economist Jeremy Cook. This dwarfs moves seen post Lehman Brothers, 7/7 [the London terror bombings], and other major geopolitical events in the past decade.
The European Central Bank said the SNB had made the decision of its own accord. Last month, ECB President Jean-Claude Trichet urged countries not to go it alone with currency interventions but rather take any action as a group.
Analysts said the SNB should be able to defend the level of 1.20 francs per euro but its success depended on efforts to deal with the euro zone's debt problems.
In the very probable event that the eurozone crisis worsens in the coming months, intervention could be very costly for the SNB, said Rabobank senior currency strategist Jane Foley.
It will be the direction taken by the euro zone crisis that will determine how successful the SNB will be in protecting the Swiss franc from strength in the coming months.
The SNB also set a formal exchange rate target in 1978 -- against the German mark -- when the franc was soaring in the turbulent aftermath of the oil crisis.
The last time they tried it was in the 1970s and it worked in the short term, but it came at an enormous cost and led to a huge burst of inflation, said Simon Derrick, head of currency research at Bank of New York Mellon.
The move now should work in the short term, but in the long term they are providing investors who are looking to exit the euro zone debt crisis with an easy route.
The SNB move came just after data showed Swiss inflation eased by more than expected in August, dipping 0.3 percent from a month earlier, lower than a median forecast in a Reuters poll for a fall of 0.1 percent.
The SNB cut an already low interest rate target to nil on Aug. 3. It is also boosting the amount of liquidity in the banking system, and had threatened further steps.
Those measures had temporarily helped the franc weaken, falling some 18 percent against the euro, but it jumped again last week as worries about the health of the global economy intensified, increasing pressure on the SNB to act again.
Expectations that the SNB could intervene had increased in recent days after top Swiss politicians and business groups expressed support for the central bank as well as the idea of an exchange rate target.
Such political solidarity is in contrast to earlier this year when the central bank came under fire for running up a huge loss in 2010 trying to keep a lid on the franc, prompting calls for SNB chairman Philipp Hildebrand to resign.
The difference now is that the strong currency is beginning to throttle the economy. Exports have weakened and the tourism sector has suffered; overnight hotel stays by foreign visitors fell 4 percent on the year in July.
Company profits have also begun to suffer, with some businesses extending working hours and others wanting to pay staff in euros in a bid to offset the rampant currency.
Swiss speciality chemicals maker Clariant AG cut its 2011 sales target on Monday due to the franc, and the key Swiss banking sector has also seen profits squeezed.
To help ease some of the ill effects of the strong currency, the Swiss government has proposed 870 million francs in aid to boost unemployment insurance and other steps, including support for the hotels sector.
Rudolf Minsch, chief economist at business lobby group Economiesuisse, told Reuters he backed the move:
This is a temporary measure that is absolutely needed to keep jobs in Switzerland and in the export industry because even at the value of 1.20, the franc is strongly overvalued.
(Additional reporting by Katie Reid)