While inflation has existed as long as money itself, cryptocurrencies are a rather new concept.
Understanding both and navigating through their relationship can help investors understand and benefit from the dynamic cryptocurrency scene.
Let’s start with inflation, which broadly refers to rising consumer prices within an economy over time. Depending on the context, inflation can be both good and bad.
Below are some key takes on the benefits of inflation.
Why is inflation good?
Inflation can be beneficial for driving spending.
Inflation is the reason that the price of a car will be more expensive tomorrow than it is today. You might put off buying that car, and if everyone does this and nobody spends money, companies stop reaping profits and wages ultimately fall.
Inflation drives spending, which in turn drives production, raising profits and leading to higher wages. These higher wages then prompt further spending. Keeping this prosperous cycle running is partly why a moderate level of inflation is considered imperative by the central banks.
Inflation eases the burden on debtors.
Here’s a simple example: a government that borrows $10 from another entity has to pay back $8 in real terms a year later, as a result of inflation.
On the contrary, if deflation was the norm, the government might have to pay back $12 in real terms a year later. Suddenly, borrowing seems a lot less attractive. Debt is a major source of economic growth. If inflation was not present lessening the debt burden, borrowing would likely decrease and have the effect of slowing growth.
With that being said, most people may not question the rate of inflation before purchasing a burger or taking out a loan. The view that inflation can be a good thing as a result of lessening the debt burden has received plentiful criticism, especially from the precious metals and cryptocurrency communities.
Why is inflation bad?
Inflation might encourage people to engage in riskier investments ‘
Given that inflation erodes the value of idle cash, people are strongly encouraged to put their money into assets. Sometimes, this prompts people to go and purchase assets beyond their risk tolerance; it might be prudent for a hedge fund to allocate a small percentage of its portfolio to a new cryptocurrency, but it might be a riskier idea for the average retail investor. From the dot-com bubble to the recent cryptocurrency market crash, many such risky investments have turned red.
Inflation-targeting can lead to runaway inflation.
Inflation is self-fulfilling. Imagine a worker at a grocery store, who sees the prices of everything around him rising, and because of this, asks his boss for a raise. The boss agrees, but realising that his labour costs are skyrocketing, he raises the prices of his groceries to remain profitable.
In essence, price increases just lead to further price increases. Imagine going to the store tomorrow and seeing that apples just doubled in price over the course of a day. If producers keep hiking prices faster and faster, price stability in an economy collapses and people panic – economists refer to this as the wage-price spiral.
What inflation can be considered as good?
Moderate inflation is generally considered good.
Disasters like the wage-price spiral and debt crises can occur in hyperinflationary environments. That’s why central banks usually aim for a moderate 2% inflation. Interestingly, however, Harvard economics professor, Benjamin Friedman, called that 2% target “a professional embarrassment”, citing a lack of serious empirical research underlying that value.
When inflation deviates significantly from 2%, central banks will either loosen or tighten monetary policy. And today, it is such monetary policy that most influences cryptocurrency prices.
Is inflation good or bad for cryptocurrency?
Inflation is generally good for cryptocurrencies when it is hovering around central banks’ 2% targets During these periods, monetary policy is loose; interest rates remain low, and riskier asset classes like cryptocurrencies benefit.
Conversely, when inflation starts exceeding the 2% target, cryptocurrency prices tend to drag. Runaway inflation prompts tightening monetary policy. When interest rates rise, markets rally towards safer assets – especially established commodities like gold or silver. For example, in the earlier stages of the COVID-19 pandemic, gold prices surged.
Though cryptocurrencies were initially intended to function as hedges against inflation, that’s not really the case today. However, it might be in the future.
Perceptions toward cryptocurrencies change with time
Recently, cryptocurrencies have behaved much like technology stocks. Low inflation kept interest rates low, under which cryptos thrived. High inflation prompted hiking, and the price of cryptocurrencies fell across the board.
This wasn’t always the case, though. There was a time when Bitcoin, for example, had no clear correlation with the rate of inflation, economic policy, or the performance of stocks. A similar trend is emerging once again and the correlation between different cryptocurrencies to technology stocks and central bank policy is fading.
Despite interest rates rising, Bitcoin has remained more steady in value relative to technology stocks than it was in the past. This is because perceptions towards Bitcoin are evolving; once considered a security, Bitcoin is now interpreted as more of a commodity, as people come to appreciate its established scarcity.
Perspectives toward other cryptocurrencies will evolve, and there’s no “one-size-fits-all” approach when linking inflation rates to cryptocurrency price movements. Nuance matters: How large will future interest rate hikes be? How are crypto protocol changes expected to play out? Which cryptocurrencies are we talking about? Indeed, it is such nuance combined with being up to speed on expected policy actions that can help investors navigate through the cryptocurrency space.
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This publication is for informational purposes only and is not intended to be a solicitation, offering or recommendation of any security, commodity, derivative, investment management service or advisory service and is not commodity trading advice. This publication does not intend to provide investment, tax or legal advice on either a general or specific basis
