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The Impact Of Inflation On The Cryptocurrency Market

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Is crypto a hedge against inflation or is it affected the same way as other risky investments?

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Research
One Button Capital
July 24, 2022
Jul 24

Cryptocurrencies have been historically regarded as a hedge against inflation. Their susceptibility to external market factors and non-correlation to traditional assets were solid case points in the last decade.

The recent widespread bear market, record-high inflation rates, and correlation between crypto and tech stocks have made many investors question if the traditional thesis is true.

In the following study, we will analyze the impact of inflation on the cryptocurrency market and answer the question of whether the FED’s policy to reduce the money supply will cause the death of decentralized currencies.

Image Source: Investopedia

What is inflation?

Inflation is the decrease in the purchasing power of money through increased prices. It occurs when there is an increase in the supply of money and credit relative to available goods and services.

In the US, it is measured by the Consumer Price Index (CPI), Producer Price Index (PPI), and Personal Consumption Expenditures Price Index (PCE).

Other countries measure inflation with similar metrics, but all of them track the change in prices consumers pay and producers receive across the economy.

Most economists consider a small amount of inflation a sign of a healthy economy. A moderate inflation rate encourages you to spend or invest your money today rather than pile it up (a problem of deflation).

Hyperinflation

  • Hyperinflation occurs when an economy experiences a rapid and uncontrollable rise in prices.
  • Economists define hyperinflation as a sustained monthly inflation rate of 50% or more.

Stagflation

  • Stagflation occurs during a long period of very high unemployment, slow economic growth, and high-interest rates.
  • As unemployment rises, consumers spend less. This decline in demand reduces prices, readjusting your purchasing power.

What Causes Inflation?

There are two primary causes of inflation’s gradually rising prices: demand-pull inflation and cost-push inflation. Both are rooted in the economic fundamentals of supply and demand.

  • Demand-Pull Inflation

Demand-pull Inflation is the inflationary condition that occurs when there is an excess demand for goods and services in relation to their supply.

At the onset of the coronavirus pandemic, for instance, the increase in demand for indoor, socially distant activities caused companies to fall short on production supplies. This resulted in steadily increasing prices.

  • Cost-Push Inflation

Cost-push inflation is when companies increase their prices because the cost of raw materials and wages have risen. Typically, this is due to an external factor that hinders a company’s ability to produce sufficient quantities of a certain good.

Image Source: Investopedia

Quantitative easing vs. quantitative tightening:

Quantitative Easing (QE) is a monetary policy strategy used by central banks like the FED in an attempt to reduce interest rates, increase the supply of money, and drive more lending to consumers and businesses.

Quantitative Tightening (QT) is a monetary policy strategy used by central banks to decrease the amount of liquidity or money supply in the economy. It is the reverse of QE.

Both quantitative easing (QE) and quantitative tightening (QT) are used by a central bank to manage the money supply and interest rates, although they’re employed in completely opposite ways.

QE was widely used during the 2008 financial crisis to prevent the collapse of big banks and other businesses. In more recent years, it has also been used to stimulate the economy, particularly when interest rates are already at historic lows.

The drawback of this strategy is that it requires the central bank to print more money, which can have the opposite effect and contribute to inflation.

The FED said “NO” to money printing.

Beginning in June 2022, a number of online news sources reported that the Federal Reserve would begin quantitative tightening, the process of reducing its $9 trillion balance sheet, which had grown in recent years).

The news led many crypto analysts to believe that it would negatively impact the prices of the decentralized currency market. The main argument is: “If QE or money-printing increased the price of Bitcoin (BTC) and other cryptocurrencies, then QT would have the opposite effect.”

What will be the effect on the markets?

Analysts from crypto exchanges and investment organizations disagree on whether QT will terminate a decade of crypto market expansion. Other financial markets have the same debate on the effects of this new measurement.

UBS Group AG, a seven-time World’s Best Wealth Management Bank, forecasted QT won’t be as significant as QE, indicating that it is far less likely to reach pre-crisis levels.

Going more in-depth

  • QT will be much smaller than QE.

The Fed’s balance sheet will not fall back to pre-crisis levels. It is impossible to erase several trillion dollars from the economy. Printing more of it, on the other hand, has been shown to be an easy task.

  • QT won’t reverse QE’s impact on long-term rates.

By buying long-term bonds and mortgage-backed securities, the Fed expected quantitative easing to push money into areas such as corporate bonds, thereby lowering corporations’ borrowing costs and, it was hoped, sparking the productive use of capital. But recent results indicate that this strategy does not work.

  • QT should not significantly impact liquidity or inflation.

QT is also unlikely to have a significant impact on liquidity or inflation. Changes in liquidity or inflation conditions occur when there is a mismatch between supply and demand for cash. In the financial crisis, liquidity preferences rose, and so central banks “printed money” in response. In fact, if the Fed were not reducing liquidity supply now, cash supply would exceed demand and inflation could become a serious problem.

Crypto Correlation to the Stock Market

Bitcoin is famous for being the digital gold of cryptocurrencies. The vision of Bitcoin evangelists is that within 15 years the asset will be the world’s main reserve currency.

The similarities between BTC and gold suggest that such a scenario is possible. And in a world where Bitcoin has that kind of dominance, it is safe to assume that the asset would be a great hedge against inflation.

But at the time of conducting this research, the market capitalization is still too small to have a meaningful impact on the global money supply and inflation. The mass adoption percentage as of Jun 2022 is <10%, which is not enough yet for Bitcoin to be treated as a commodity at the level of gold.

The current market cap of Bitcoin is 3.4% of that of Gold, and at its peak, it was close to 10%. Source: 8marketcap

In reality, Bitcoin is a speculative asset, just like every other cryptocurrency or risky investment. And until BTC has significant mass adoption and market cap, it will be treated as a risky asset or investment to be traded with the purpose of profit.

BONUS:
Even though the case study of gold being a hedge against inflation has 70 years of data, in certain times when everything is going down, the precious metal value is also suffering.

Chart of 2020 by SunShine Profits, showing the performance of gold (yellow) and SP500 (green).

Conclusion

Inflation is the invisible villain who devalues your money. It is caused by a variety of economic factors, the most significant of which is the massive amount of printed money over the last 50 years.

Governments have begun the practice of quantitative tightening in order to reduce the impact of inflation, but this has its own set of consequences. All markets are currently suffering and in a slump. Crypto, with Bitcoin at the forefront, is no exception.

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