What is the relation between crypto and inflation? The cryptocurrency and inflation is a hot topic for discussion, if not a debate, and it is rightly so, because these two things have a very close relationship.
When there is inflation, the crypto prices are also supposed to be affected because more and more people will use it as a hedge for their fiat money and also to protect their buying power at the same time.
And, just as the stats reveal, inflation has really happened in the past decades at probably the fastest pace.
Since crypto is extremely volatile, the relationship between the two seems to be pretty obvious.
A lot of industry analysts try to analyze the role of crypto in the world that is facing high inflation persistently.
Given the fact that Bitcoin in particular is designed to combat inflation successfully, they wonder whether or not it will prove its mettle given the current financial situation of the world economy that has been hit by the pandemic caused by the Coronavirus.
A lot of governments started printing more money which helped the inflation to remain stable at about 1.5%.
This has put the governments in a difficult situation now that the world economies have started to reopen and purchasing power of the consumers is picking up.
Though economists believe that low level of inflation is good in a way that it creates new jobs at downtimes and boosts the economy by stimulating spending, borrowing and investments.
All these are necessary for a healthy economic growth. But, if it goes out of control and causes hyperinflation, wages will stagnate and prices of goods and services will go up rapidly.
Here comes the role of crypto as explained in this article.
What is the Relation Between Crypto and Inflation?
In a situation when inflation is on the high, so much so that it can be termed as hyperinflation, the purchasing power of the national currency decreases and the cost of living becomes more expensive.
When the inflation rate is high, the value of money will erode and if the inflation is low it will slow down the economy on the whole.
Therefore, depending on the specific situation you will have to prioritize your spending.
The value of the currency is affected during inflation, high or low, and there is no doubt about it.
This will result in a decrease in value of the money you have in your savings account with the bank.
Now, the crypto coins, especially Bitcoin, can help in such situations because it has a unique relationship with inflation in terms of its price.
It is for this reason most of the Bitcoin investors consider it to be a good prospect to beat inflation. As a result, they put more money into it.
Now, if you consider cryptocurrencies in general, different people usually invest in this digital asset class for varied reasons such as:
- Some people invest in it simply to book profits
- Some people invest in it considering it to be a quick and easy way to build more wealth and
- Some other people invest in it considering it to be a good store of value.
However, most people agree on one particular point when it comes to crypto, especially Bitcoin: it acts as an effective hedge against inflation.
Typically, the value of Bitcoin is almost certain to rise at a rate that is much more than the rate of inflation.
Therefore, investing in crypto coins like Bitcoin may prove to be a good strategy that will increase the net value of the investment.
This is because its value will remain positive even when the value of their savings continues to erode away due to inflation.
Also, the fact that the value of Bitcoin has risen rapidly over the past year made people believe in its growth potential and ability to beat inflation.
That is why more and more people are now entering into the crypto space rather than investing in the traditional assets with value such as gold.
The investors all over the globe are also worried at the rate at which the value of gold has fallen YTD in comparison to the rate at which the value of crypto coins has risen due to inflation.
This is another reason people consider it to be a good hedge against inflation.
And, the fact that Bitcoin comes with a finite supply of 21 million makes it a scarce commodity, just as gold.
This also makes it a better option to invest in rather than in the yellow metal.
Now, the question is whether or not inflation is going to stay, and if so, will Bitcoin still prove to be a good hedge against it.
Well, with the prices of global crude oil increasing every day almost in leaps and bounds, it is highly likely that inflation will stay for a long time and the rate will even increase further in the near future.
Typically, inflation has caused a lot of problems in the supply chain.
The world economy now has to deal with monetary policies with more aggression bringing in several policy effects and narratives.
Even intricate cost curves such as the ‘Phillips Curve’ are now being used to analyze the effects of inflation in health policies and financial stimulus.
The Phillips Curve refers to the policy responses of the world during an inflation run that results eventually in an oversupply of currencies which chases after less and less goods naturally.
It also refers to an economy that does not respond to monetary stimulus which results in stagflation, a condition characterized by high inflation, high unemployment, and high political unrest.
With such an effect, you may naturally tend to think whether or not the results of COVID 19 is transitory or is here to stay and what specific role can Bitcoin play in dealing with such a situation.
Well, here are a few facts discussed for your better understanding of the role of Bitcoin during inflation.
- First, you will need to understand that the effects of inflation are felt all over the globe and not only in the United States as it is often portrayed by the media wrongly. This is a very important thing to consider for understanding the role of Bitcoin in such situations.
- Secondly, inflation is pretty hard, if not impossible, to foresee academically though in general terms the economists usually see inflation and unemployment as a tradeoff. It can be either high inflation and low unemployment or low inflation and high unemployment. Most central banks of the world as well as the Federal Reserve also follow this concept while creating policy prescriptions or a mandate to ensure that the economy is keeping inflation within a low band and a certain stable limit and at the same time is performing towards creating more employment.
- Thirdly, it is necessary to putrefy the temporary and permanent causes of inflation in the first place. This will help in dealing with the inflation that is mainly caused due to the issues with the supply chains which however will pass away during the adjustment period to normalize the implausible economic turmoil.
However, this situation is expected to go down when there is an increase in overall demand that will bring back the economies to life.
This will stabilize the supply chains and eventually create a ‘normal’ economy.
As said earlier, with inflation comes a global increase in the supply of money due to printing new currencies by the government, and this has expedited radically after the COVID 19 due to specific policy response.
If you consider things over the long term, you will see that there is quite a strong relation between inflation and the expansion of money supply.
This is the specific relation that Bitcoin is designed to address most effectively.
It is well positioned and has all the abilities to deal with the situation on a longer time range of the Phillips Curve.
There are lots of people who consider crypto as the digital alternative to the US dollar, and they are true in some ways.
How? Well, once again, it is due to its connection with inflation.
Yes, it is true that as of now not all merchants are receiving crypto coins such as Bitcoin and Ether as a mode of payment but it is showing good signs for a mass adoption and acceptance as an alternative payment mode.
There are already quite a few major and popular retailers and e-tailers that have started accepting Bitcoin.
Looking at it closely, it can be expected that this number will grow and the whole business fraternity will accept digital currencies as an alternative, if not the only, mode of payment.
The big movements and growth rate of Bitcoin and other crypto coins in the past year has shown that these digital currencies can beat inflation successfully and therefore can be used as a mode of payment when and if the value of dollar erodes due to hyperinflation.
And, a lot of investors have already started making huge investments in this specific asset class instead of gold and other precious commodities.
They hope that it will store and build wealth and also increase in value at the same time, all of which will make it less susceptible to the fluctuations of the value of the US dollar.
However, this is not an ‘absolute’ case because there can be big swings in the price of crypto coins, especially Bitcoin.
This may cause inconsistency and any currency that is inconsistent cannot outpace inflation.
This means that even Bitcoin is somewhat unreliable with its prices falling significantly last year and also showed some signs already within these couple of months this year.
Ideally, experts and analysts say that Bitcoin is not a good one to be considered as an everyday currency.
They say that when the value of a currency swings equal to or greater than 10% in any direction higher or lower just in a matter of days, it cannot be considered as a trustworthy tender to make a purchase.
A coin with such high volatility also means that it is not only a risky currency but is an unsafe asset class to make an investment in as well.
Now, considering the current inflation, things should be seen from a different perspective and much more closely as well.
This particular inflationary period that the entire world is going through is much different from history, right from its cause to its effects.
The recent inflation is primarily caused by the quirks related to the pandemic such as:
- Rise in the prices of the commodities
- Disruptions in the supply chain
- Changes in labor force and
- Increase in demand for goods.
The financial experts believe that this inflation is much more severe than those before and, most importantly, it has already lasted for quite a long time than they expected it would.
The classic and more favored hedges against inflation such as gold have not performed in this situation as well.
This is because the current complex situation defies the basic principle of inflation: when inflation increases, the value of the hedge investments also increases along with it.
However, this has simply not happened this time.
The current inflation has also defied another common and basic logic of inflation.
Much unlike other occasions when there was a rise in price of commodities due to inflation, it has not affected the growth rate much adversely.
This has benefited the US dollar making it more stable to grow your confidence in its ability to retain its value against hedge funds including cryptocurrencies.
Now, given this situation a natural question may arise: how able is crypto to prove to be an active hedge against inflation in this connection and in the given situation.
Well, experts say that those who have already invested in Bitcoin and other crypto coins should not count on it blindly and consider it to be an active hedge against inflation.
This may look like quite a savvy move but the investment as such is so youthful and the crypto industry on the whole is so immature that nothing can be said for sure.
It remains to be seen how productive it is because as of now the risks involved in it are less understood by the users and this particular asset class is more complex to evaluate with respect to other securities.
In short, crypto as of now has too brief a history to envisage its future performance and should be considered as a volatile investment opportunity.
You will need to set specific goals for its performance if you wish to own Bitcoin or any other crypto coin to diversify your investment strategy.
This will help you to avoid making emotional decisions while investing as well as guide you to take necessary actions when the price of the coin reaches up to a certain limit.
Investors should remember that crypto may transform the world of finance but as of now crypto and blockchain technology is quite cloudy.
However, it is just the start of an exciting future.
There is no denying of the fact that the blockchain technology underlying crypto that verifies a transaction has the ability to transform the way daily financial transactions are made, and beyond.
However, whether this innovative technology and digital asset will be a good hedge against inflation remains to be seen.
Bitcoin has become more aligned or pro-cyclical with wider movements in the market due to the recent institutional investment.
This means that if the market falls, the price of Bitcoin will also fall which signifies that when inflation strikes, Bitcoin may not necessarily prove to be the perfect hedge.
This is due to a distinct connection between crypto prices and inflation.
Typically, when there is any news of inflation striking in the United States, the market will fall.
This is because it will weigh on the dual mandate of the Federal Reserve and will bring in a forced change in the posture of the central bank of America.
It will also bring a change in the interest rates of the policies.
If this rate increases or if there is a monetary contraction, the prices of the assets will fall, and this includes Bitcoin.
Ideally, investing in Bitcoin for hedging against inflation is more of a technological, cultural, and philosophical story rather than a financial one.
Decomposing the Phillips Curve will help you understand the long term implications of it.
The fundamental principles of Bitcoin to be an international currency without any specific domestic polity to impose robust technical constraints to control the supply of the coins will also give a clearer line of sight.
According to the Phillips Curve, any monetary policy that results in high inflation rates will create the perfect recipe for a terrible economy in the long run where the low wage earners, savers, and anyone dominating their worth in fiat will be punished severely.
In addition to that, it will also create a condition where a more permanent and constant check will be needed in the long term to control the money supply growth and inflationary factors.
This will help in combating the principal source of established and long-standing inflation directly.
Though research does not substantiate the potential of Bitcoin to be a hedge against inflation, it surely has quite an important role to play in this regard.
Bitcoin plays a more subtle role as a hedge against inflation and therefore the financial impact should be understood and separated depending on different time scales.
However, the growth potential and other prospects of Bitcoin have made it a more popular alternative investment option to safeguard fiat money over the past couple of years.
Bitcoin is basically a deflationary asset which is why people living in countries with unsteady fiat currencies are using it more and more as a store of value.
They believe that it will save them from the harm caused by hyperinflation and the rising prices of everyday goods and services.
The fact that it cannot be manipulated to the same level as fiat money by increasing the supply makes it an attractive and resistant asset with a store of value to deal with inflation, though the volatility of the coin could be a viable concern.
However, if you are worried about the volatility, which is a viable concern since the prices of Bitcoin can drop drastically by up 50% at times, you can choose to invest in the stable coins as an alternative if you want more stability.
These coins pegged with USD at 1:1 ratio will also benefit you in a lot of different ways in hyperinflationary conditions such as making easy day to day transactions.
Rethinking Inflation Hedging Power of Bitcoin
With all the things said above, it is time to rethink the power of Bitcoin to be an effective hedge against inflation though it is far too early to judge it.
Typically, when it comes to investing in Bitcoin one thing is very clear: it is the rich that gets richer.
Inflation hits every aspect of the economy, business, and avenues of human activity.
Whether it is the price of gas to any other everyday commodity, from clothes to supply chains, healthcare to the value of dollar, everything seems to feel the impact of inflation.
And, the specter of inflation hits the entire globe with rising rates of inflation. It affects the purchasing power of the consumers and the government to design a better economic plan.
In order to prevent them and their savings from the inflationary inferno, people and business organizations sought solace in other alternatives to hedge against inflation to save their devaluing fiat currency.
Bitcoin and several other crypto coins seem to be the best available weapon of choice as of now.
Its growing popularity has even forced the US Securities and Exchange Commission or the SEC to consider cryptocurrencies as a worthy asset class to invest in.
Bitcoin, in particular, is the most favored alternative hedge against inflation because it has provided high returns YTD and has even outshone the conventional hedges by rallying more than 130% as compared to the paltry 4% return offered by gold.
In addition to that, there is also an increased adoption of Bitcoin by the institutional investors proving that it offers a more sustained growth exposure.
The weekly inflows have strengthened the belief in Bitcoin even among the weary investors.
However, with all the prospects offered by Bitcoin to make big money, whether it is a smart move to invest more in it no matter how enticing it may seem apparently still is not clear.
Quite naturally it raises a few good questions over the viability and ability of the coin in extenuating financial risks, and there are a few good reasons for it.
Misconstrued speculations and expectations is one particular reason. Such miscalculations are pretty common in the crypto market due to the jitters and gyrations that this market is susceptible to.
Bitcoin has yet to prove its ability to reduce volatility and produce constant returns over the long term especially during inflationary situations just like gold has proved its efficacy no matter how insignificant it is in comparison to what is portrayed by Bitcoin as of now.
The limited supply concept of Bitcoin is another significant point that raises some argument.
It is said that Bitcoin is designed to protect itself from devaluation due to its finite supply of 21 million in all.
They say this is what the fiat money lacks. However, all these seem to be exceptionally theoretical.
This is because history shows that Bitcoin price is vulnerable to external factors such as the ‘whales’ who manipulate its price by buying and selling the coins in huge quantities. This means that the price of Bitcoin can be controlled and altered by speculative forces and not by the money-supply theory exclusively.
Regulation is another aspect to consider because Bitcoin and all other crypto coins are at the mercy of the regulators and the laws differ wildly across jurisdictions.
A few regulations are shortsighted and a few are anti-competitive, while others are both.
All these rules and regulations dampen the prospects and possibilities of adoption of the technology underlying crypto.
This actually drives the price of the coins further south.
As said earlier, Bitcoin caters to the rich.
This is because the growing popularity of this particular crypto coin has driven institutionalization and wide adoption of it among consumers that include corporations as well as affluent individuals both.
This is because this unregulated and uncorrelated asset has allowed them to diversify their portfolios more easily and efficiently.
There has been too much Bitcoin advocacy from the prolific personalities and technologically progressive billionaires and powerful companies showing their interest in Bitcoin as a feasible investable asset.
This may also raise some questions because if such momentum continues then the infamous volatility of Bitcoin will gradually and eventually dissipate.
However, ironically, it will also result in concentration of wealth since more and more rich people will invest and hold this particular asset.
Therefore, it will make the small percent of the exclusive and elite people richer.
This will leave the majority deprived making Bitcoin an antithesis of its primary objective for creation.
Holding too much Bitcoin by a few people and institutions will also create a perfect scenario for whale-like market control.
This is because the insignificant percentage of rich people will now be able to increase the prices of the asset in the short term to get a bigger slice of the crypto pie.
The traditional retail investors who are less influential and less wealthy will not be able to do so.
Therefore, the fact that Bitcoin will make only a few people wealthier and leave the entire crypto market at the mercy of these few people actually contradicts the intended vision of the coin itself.
According to the financial experts, such situations will expose the retail investors to higher amounts of risks and therefore they may back out from dealing with cryptocurrencies further.
When such a thing happens and the control of the crypto market shifts to the more influential people and firms with ultra-high net worth it will be against the basic ethos of Bitcoin white paper.
Ideally, it is supposed to be used as a P2P electronic cash payment system that is free from any external control and censorship of any government and institution and is permission-less.
Inflation is a complex concept of economics and crypto is an equally complicated subject. Both need a better understanding to determine the relation between the two.
Hope, this article has been able to enlighten you about it in the best way possible.
I have special interest in crypto and intend to help common people to gain knowledge about the digital asset as well as its potential. Follow Me at Linkedin.