What is inflation?
Never far from the global debate, inflation is one of the main talking points for politicians, central bankers and everyday citizens at the moment. Let’s start with an overview of the subject:
Inflation is defined by rising consumer prices within an economy that indicates the currency supply has been overly increased relative to the supply of goods and services. The result is a devaluation in the buying power of that currency over time.
Let’s say you have £100 pounds in a UK savings account that pays a 1% interest rate over the course of a year. After one year, you would have £100 pounds in your account, but if the inflation rate is recorded at 10% that year, you would have lost a significant amount of buying power. In other words, your cash would now be worth £91 in real terms, adjusted for inflation.
Fiat Currencies Explained
Since the start of the millennium, the value of money has been steadily decreasing, in relation to the value of gold, in part due to the valuation of fiat money and credit creation. Relative to gold, for example, the value of the dollar has almost totally declined, with the currency having lost 98% of its buying power since 1971.
While this is a more recent example, it does reveal the mechanics of the fiat currency system; according to Dalio, ‘of the roughly 750 currencies that have existed since 1700, only about 20 per cent remain, and all of them have been devalued’.
The British Pound, Chinese Renminbi, the US dollar as well as the majority of global currencies in circulation today, are known as ‘fiat’ currencies – government-issued money, not backed by a physical reserve commodity, such as gold or silver.
So what does the future hold for today’s fiat currencies?
What is the cost of inflation?
While many have already witnessed the devastating effects of high inflation, there is still some debate among economists about whether there is such a thing as ‘good’ inflation. The Federal Open Market Committee (FOMC) judges that inflation at a level of 2%, in the long run, is the target for the US central banks’ mandate to stimulate maximum employment and price stability within the economy.
However, when there are high levels of inflation for a sustained period of time, this can have a negative impact that extends beyond the monetary and into the political sphere, fostering a general distrust for those with the job of maintaining economic stability.
Coupled with low or negative interest rates, there is no longer enough compensation for the increased supply of money in the financial system, and if left unchecked, this eventually leads to a self-reinforcing decline in the value of money.
A recent example of this was in 2018 when the inflation rate in Venezuela hit over 1,000,000% a month, causing the economy to collapse and many to leave the country. The real cost of inflation is felt throughout the economy. It has the potential to further cement the divide between people in higher and lower socio-economies brackets, increase unemployment, and stunt the nation’s growth of business and trade.
What does inflation mean for cryptocurrency?
Alongside the discussion around inflation, some advocates have argued that cryptocurrencies such as Bitcoin can stand in as an inflation-hedge, in place of precious metals or other commodities.
Advocates of Bitcoin (BTC) have argued that it is the asset’s scarcity – which is determined by its fixed and limited supply of 21 million – that protects holders of the cryptocurrency during times of rising inflation. This differs greatly from fiat currencies, which can be printed and created by central banks at any point – devaluing the currency as the supply increases.
However, the question of whether unbacked cryptocurrencies offer sufficient protection against inflation is yet to be proven. The price of cryptocurrencies is typically volatile, with major tokens that have large market-caps such as Bitcoin and Ethereum prone to 5-10% swings. This volatility often results in their mixed performance against fiat.
Since inflation has run rampant, the value of the cryptocurrency market has plummeted to an estimated $1 trillion, with Bitcoin losing half of its value since January this year. Bitcoin is now trading at around $19,300 at the time of writing.
With many viewing the ‘crypto boom’ as a surefire way to protect from inflation, it seems that it is still worth considering tried and tested methods before taking the leap on every new token or coin that appears on the market.
How to protect yourself against inflation?
Investors typically allocate a portion of their capital to a store hold that traditionally holds its value over time – particularly during periods of prolonged inflation. Gold has been one of the most reliable and durable assets to do so, being immutable, scarce and universally accepted as ‘valuable’ throughout history.
Since the US uncoupled gold from the dollar in the early 70s, the precious metal has seen a gradual increase in its price trajectory. As well as offering a track record for storing value, gold’s performance during times of high inflation has presented a return of 15% per annum on average, when inflation has been higher than 3% (reported the World Gold Council). However, it’s not just retail investors who are stocking up on precious metals, governments and central banks worldwide are making sure to keep their coffers full, with global gold reserves at their highest level in almost 30 years.
Zimbabwe returns to gold currency
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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.