The two main digital assets, Bitcoin and Ethereum, offer the best case study for the link between crypto and inflation.
- Inflation is a sustained upward trend in the cost of goods and services across an economy.
- Crypto inflation can be understood as introducing new coins to the circulating supply, typically by miners and validators.
- As investors shift their focus to safer investments, the demand for risky assets may decrease, further exacerbating the bearish sentiment in the crypto market.
Many people fronted crypto as a possible hedge when inflation peaked recently. The logic for the frequent promotion of crypto as an inflation hedge is that fiat currencies would ultimately lose value due to central banks issuing money. However, not many people have a proper understanding of the relationship between crypto and inflation.
Inflation, in simple terms
The standard definition of inflation is a sustained upward trend in the cost of goods and services across an economy. Additionally, hyperinflation coincides with the economy’s currency losing purchasing power. As inflation rises, consumers must purchase a certain quantity of goods and services with growing currency units.
Inflation affects every commodity or service, including utilities, vehicles, food, healthcare, and housing. Currency devaluation in times of inflation affects businesses as well as individual customers. Inflation reduces a consumer’s purchasing power, weakens savings, and delays retirement. Central banks globally monitor inflation so that they can respond accordingly.
Central banks use indexes such as the Consumer Price Index (CPI) and the Producer Price Index (PPI) when measuring inflation. Consumer price increases are often confused with monetary inflation. However, Central banks have little direct control over the former but can influence the latter.
Monetary inflation is a sustained increase in a country’s money supply or currency area. The money supply is the summation of currency and other liquid assets in a country’s economy on the date measured. The supply includes all cash in circulation and all bank deposits that the account holder can easily convert to fit currency.
Governments issue paper currency and coins through their central banks, treasuries, or a combination. Banking regulators can increase or reduce the available money supply through policy changes and regulatory decisions to control inflation and stabilize the economy.
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Understanding crypto inflation
Crypto inflation can be understood as introducing new coins to the circulating supply, typically by miners and validators. The two main digital assets, Bitcoin and Ethereum, offer the best case study for the link between crypto and inflation. For instance, with over 90 per cent of Bitcoin (BTC) in circulating supply, the asset’s inflation rate has fallen significantly over the years.
Bitcoin’s dropping inflation rate stems from the cryptocurrency’s fixed supply of 21 million BTCs. The rate drops after every four years during the halving event. As a result, the maiden cryptocurrency’s inflation rate has been steadily declining since its inception in 2009 to around 1.8 per cent as of March 4, data by crypto analysis platform WooBull indicates. The next Bitcoin halving event comes in May 2024.
In the case of Ethereum, the inflation rate is variable depending on network usage and miner rewards, which have changed since the Merge. Pre-merge, Ethereum was inflating at about 4.6%, but post-merge, many expect it to drop below 0.5% per year and turn negative if network activity increases further.
The inflation rate for Bitcoin and Ethereum is already low, and there will be even lower supply growth in the future. The digital asset space is a small and volatile fragment of the economy (about $1.22 trillion total market cap at the time of writing).
Minor changes in the supply of cryptocurrencies are not likely to have as great an impact as a significant change in the consumer price index (CPI), monetary inflation, and policy. Some people believe that Bitcoin halving events drive crypto price cycles. However, given the space is now more institutionalized, correlations to the macro-economic landscape seem more likely.
Crypto and money inflation
Some people question crypto as a store of value and its potential to act as a hedge against inflation when looking at the CPI. But research has shown that any correlation between the CPI rising and crypto price, if any, it is negative. If consumer prices increase, crypto price usually falls. The same holds for the entire digital asset space.
When people face price increases on the items they need the most, they have less disposable income available. Considering that necessities like buying food and paying energy bills rank higher in priority than cryptocurrencies, it is normal for people to reduce their spending and overall exposure to digital assets.
Monetary inflation typically leads to an increased CPI. But monetary inflation does not measure the prices that consumers and producers pay. Instead, it measures the amount of money in circulation. When the money supply grows, crypto usually experiences significant gains. When it shrinks, crypto often struggles.
Historically, the total crypto market cap has grown with the overall money supply growth and vice versa. In other words, crypto is a monetary inflation hedge, and when the money supply starts to expand again, we can expect the crypto market cap to follow suit.
Linking interest rates to crypto and inflation
Rising inflation prompts central banks to raise interest rates to stabilize the economy. When interest rates rise, borrowing becomes more expensive for individuals and businesses. This can result in reduced borrowing, lower consumer spending, and decreased business investments. Consequently, the demand for risky assets, such as stocks and high-yield bonds, may decline, leading to bearish sentiments and a price drop.
Moreover, higher interest rates make seemingly safer investments, including government bonds and fixed-income securities, more attractive to investors. This is because they typically offer higher yields when interest rates rise. As investors shift their focus to safer investments, the demand for risky assets may decrease, further exacerbating the bearish sentiment in the crypto market.
Higher interest rates can also create market uncertainty, with investors who may be unsure of how the changes will affect various sectors of the economy. This uncertainty can increase market volatility, making investors more risk-averse and cautious in their investment decisions.
The link between crypto and inflation happens as described under normal circumstances. But recently, the banking sector crisis changed how the game plays out. High rates led to higher borrowing costs, a shift to safer investments, and reduced corporate profits. All these things led to difficulties in the banking sector.
This culminated in the fall of several banks, with governments globally intervening in the sector to bring back sanity. Consequently, many turned to the crypto market as a safer investment pool. This further inspired the adoption and growth of digital currencies like Bitcoin.
The relationship between crypto and inflation is undeniable. Inflation can initially cause a decline in the value of cryptocurrencies as investors anticipate higher interest rates and a subsequent drop in demand for riskier assets. However, over time, the ensuing banking sector challenges and other negative consequences of high inflation could prompt investors to seek safer havens like crypto.
The initial reaction to high inflation is typically the risk of interest rates rising more than expected. Rising interest rates lead to a decline in all risky assets, including cryptocurrencies. Nevertheless, as the situation unfolds, cryptocurrencies may experience growth as investors seek alternative stores of value amidst economic uncertainty.
Story Courtesy of Web3Africa