Evan Soltas had an interesting post on the power of promises in the context of currency bands and monetary policy, but we should also remember that banks shouldn't try to make promises they can't keep. We all should be very worried when we see graphs that show sudden decreases in volatility, as Evan shows in his post. Whenever policymakers suppress volatility, we need to wonder where those pressures have gone, and why they have disappeared. More often then not, manufactured stability leads to calm periods punctuated by sudden change; they become Type 2 extremistan regimes, as pictured below:
So why did the currency peg work? The peg only makes sense in the context of Scott Sumner's argument that the currency peg is a form of monetary policy commitment. The undervalued currency increases aggregate demand, thereby filling the output gap. However, it should be observed that, given the undervalued currency, maintaining the peg leads eventually to above trend NGDP growth and an economy that's running "hot". However, the "hot" economy would call the currency peg into question. This is a classic example of Mundell's policy trilemma. The SNB cannot pursue an exchange rate peg, independent monetary policy, and capital mobility at the same time. Conditions are stable now only because the exchange rate peg matches the objective of an independent monetary policy. However, once the output gap starts to narrow the credibility of the exchange rate peg will be questioned.
This is where the expectations channel starts creating weird dynamics. If the market expects the SNB to pursue monetary policy that prioritizes internal conditions, then the market should expect that currency to appreciate in the future as the output gap is filled. However, because of inertial central bank policy, this will only occur when the currency is undervalued to such an extent that it is no longer feasible for the central bank to maintain the peg. At that point, we should expect to see a very sudden adjustment as the SNB comes under fire from speculators. This then creates a vicious loop, as the SNB's attempts to maintain the peg only increase the supply of currency, of which speculators buy increasing amounts as they now know that the currency will appreciate.
When the SNB is forced to rebalance the currency, it will shake up markets as it unwinds its large balance sheet of foreign assets. Since the bank would have been accumulating these assets for a long time, their sudden liquidation is likely to be a "fat tail" event, which, on one hand may not cause that much damage, but on the other hand may cause positive feedback loops to devastate markets in unknown ways.
While this analysis is in the specific context of the Swiss central bank, this argument has implications for NGDP targeting in developing countries as well. The problem with the SNB's currency peg is that it prioritizes one objective (exchange rate) over all others (including NGDP). However, when domestic politics rears its head, a internal measures such as NGDP will end up trumping external measures such as the exchange rate. The crisis arises from a sudden reversal in priorities.
This exchange rate-NGDP tension is very important for developing economies. If these countries pursue capital mobility, then they may need to compromise part of their monetary policy to maintain an exchange rate band. Thus, this is another source of possible fragility in a NGDP target, as other objectives, such as the exchange rate, suddenly come to the forefront.
Edit: Evan Soltas gave me a further explanation on how the "peg" is really a floor, as well as an explanation of the general macro conditions in Switzerland. I failed to take the time to analyze them, so the conclusions are slightly different. There's still possibilities of non-linear dynamics, and those are explained in the comment thread. I've also written a new post reflecting back of these issues here.