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Crypto and Inflation: A Complex Relationship

April 06, 2022 - 11 min read

Does Cryptocurrency Really Protect Investors Against Inflation?

For years, crypto proponents have claimed that cryptocurrencies like Bitcoin are the perfect hedge against inflation. For example, Bitcoin, with its limited supply and increasingly difficult-to-mine nature, has been hailed as the perfect deflationary asset. Thinking of Bitcoin and other cryptocurrencies as inherently deflationary has certainly increased their popularity, especially amid an environment of record inflation in the United States.

However, whether this is actually true is the subject of fierce debate, particularly after Bitcoin’s value nearly halved in early 2022, just as U.S. inflation spiked to a reported 7%

In this article, we’ll look at the arguments explaining the recent fall of Bitcoin, as well as arguments regarding why various cryptocurrencies may or may not be inflationary. We’ll also look at how various economic factors may be interacting to impact both crypto price levels and the relative prices of fiat currency. Finally, we’ll look at the potential for crypto itself to impact inflation– and whether it already has.

In many cases, we will use Bitcoin as a statistical substitution for the cryptocurrency market, as it is currently the largest cryptocurrency by market cap and has seen a strong correlation with the crypto market as a whole.

The Fed, Crypto Regulation, and Interest Rate Hikes

Conventional wisdom says that crypto markets’ recent fall was tied to two major factors; potential regulation by the Federal Reserve, as well as increased market uncertainty, particularly regarding the Fed’s potential interest rate hikes. In addition to potential interest rate hikes, the Fed has also been reducing its quantitative easing efforts, buying fewer U.S. Treasury bonds and agency bonds as of late

The Fed believes that this will keep inflation from becoming “entrenched,” though no one can predict the exact results it will bring.

In general terms, more conservative fiscal policy, including interest rate increases, leads to more conservative moves by both retail and institutional investors, so this could be leading investors to drop Bitcoin and other cryptocurrencies in favor of less-risky investments, such as stocks, and bonds, which will provide more predictable returns in a higher interest-rate environment.

Therefore, somewhat ironically for crypto investors, the Fed’s efforts to combat inflation are actually leading to inflation in cryptocurrency markets. In addition, if the Fed’s potential interest rate hikes truly do combat inflation, there may be less market demand for inflationary hedges like crypto or precious metals.

It’s also important to mention that the United States is not the only country to begin to regulate crypto. Crypto’s blanket ban in China and severe restrictions on cryptocurrency in Russia and other countries have also likely had a significant negative impact on overall crypto markets, and with that, the prices of the most popular crypto assets, including Bitcoin.

Bitcoin has had many ups and downs, and, as we previously mentioned, seemed to be becoming more popular as inflation increased. However, precipitous drops have many questioning everything they know about the economics of the most popular cryptocurrency.

One potential factor in Bitcoin’s recent nosedive is likely increased institutional adoption of the asset. Approximately 8% of Bitcoin is reportedly held by institutional investors. However, the true proportion of institutional Bitcoin holdings could be double or triple this amount. This is due to the fact that many institutions, including family offices, trusts, wealth management firms, hedge funds, and even some sovereign wealth funds are often highly secretive — and may not want the public to know about their crypto holdings.

While the average Bitcoin investor may be inclined to HODL (hold on for dear life), the average institution may, rightly or wrongly, see their crypto investment as highly speculative and therefore could be inclined to sell it at the drop of a hat, particularly if they need to rebalance their portfolio after sustaining losses. Instability in the global capital markets, particularly tied to defaults in Chinese debt markets, has already led to major losses for institutions, and, in an attempt to rebalance their holdings, Bitcoin may have been the first to go.

This, however, is difficult to prove, and, even if it is the case, is likely only one of many factors impacting crypto prices.

Bitcoin and Crypto May Simply Be Following the Market

We’ve mentioned how increased market uncertainty and institutional adoption could be the reason why Bitcoin and cryptocurrency markets tanked as of late despite record inflation. However, this may represent a larger trend. As cryptocurrency becomes more widespread, it could simply be following the market cycle of ups and downs, except with a far greater level of volatility.

Bitcoin’s statistical correlation to the S&P 500 has varied greatly over the last few years, reaching as high as 0.4 in March 2020, but it also fell as low as -0.22 during the 2018 crypto crash. For reference, a correlation of 1 would mean that Bitcoin and the S&P move in exactly the same direction, while a correlation of -1 would mean that they were moving in the exact opposite direction.

As of January 2022, the correlation between Bitcoin and the S&P was 0.35, a relative high, and the correlation between the two has been increasing since June 2021.

This would mean that Bitcoin is not a hedge against inflation, at least in the short term. Instead, Bitcoin prices have increasingly tracked overall market performance. This seems to indicate that Bitcoin is subject to the same factors, such as increased interest rates, as more traditional assets, such as tech stocks.

Cryptocurrency Utility May Also Play A Factor in Inflation

Other than Bitcoin, there are many other cryptocurrencies worth analyzing. Many believe that Ether (ETH), the native cryptocurrency of the popular Ethereum blockchain, or other smaller cryptos will eventually become the dominant market players due to the fact that they have utility beyond simply being a store of value.

ETH functions as the currency of the Ethereum Virtual Machine (EVM), the world’s largest distributed computing network. Thousands of apps, including DeFi lending and staking protocols and popular NFT marketplaces like OpenSea, are all built on the back of Ethereum, giving it a strong use case. For some investors, this has fueled the argument that ETH is a stronger and even more deflationary asset than Bitcoin.

However, like Bitcoin, Ethereum also recently fell, so it’s difficult to make the argument that its increased utility led to more price stability. Plus, unlike Bitcoin, the supply of ETH is not fixed, and, while a fair amount of ETH is burned regularly to stabilize the market value, it’s certainly possible that large issuances of ETH in the future could lead to runaway inflation.

Solana, another highly popular cryptocurrency backed by a powerful blockchain, has also seen its value tank in recent months. Solana minted NFTs are growing increasingly popular, and some believe the network could become a potent competitor to Ethereum in the coming months and years.

Due to each of these major cryptos falling in a high-inflation environment, we can safely say that in the short-term, crypto utility does not have a strong inverse correlation with inflation. However, crypto markets have drastically risen and fallen in cycles, so it would be premature to say that over a multi-year cycle, crypto utility does not increase crypto prices relative to fiat currencies.

Unlike Bitcoin, Ethereum, and Solana, stablecoins have not generally seen their prices drop in recent months. This may be due to the guarantees, however dubious, that many stablecoins are actually backed by equivalent amounts of cryptocurrency. Of course, even if stablecoins remain 100% pegged to the currency they track, they’re only as stable as that currency itself.

Therefore, it’s safe to say that stablecoins have still been subject to inflation, just not inflation beyond the currency they are pegged to. However, if Bitcoin and other cryptos were to fall beyond a certain support level, faith in the overall crypto markets could tank, and stablecoins could potentially significantly de-peg from the currencies they track.

It should be mentioned that stablecoins also do have an important utility, particularly for traders and investors who want to reduce their risk between trades or temporarily pull out of the volatile market without converting their crypto to fiat currency. This could be another, albeit small reason why stablecoins have not seen their value fall in concert with other cryptos.

Crypto and Gold: A Study in Inflation Hedges

When considering whether crypto hedges against inflation, it may be useful to compare it to a more traditional investment utilized as a hedge against inflation: gold. While often hailed as a panacea against inflation, gold has had a mixed track record during inflationary periods and has consistently underperformed the S&P 500 during nearly every decade since statistics were recorded. Researchers suggest gold’s correlation to inflation is approximately 0.16 over the last 50 years, which is hardly evidence of an inverse relationship.

Gold prices did see a spike in mid-2020 during the height of the COVID-19 pandemic, but have since fallen significantly, though not nearly as much as Bitcoin prices. Gold, of course, has utility beyond being a measure of value, as it’s used in nearly all electronic devices, as well as for jewelry and a wide variety of decorative uses, so this means that it’s unlikely to endure the wild swings that crypto does.

Gold and Bitcoin did seem to be somewhat correlated, at least for a while. However, the recent crypto downturn has not seen a corollary in the gold markets, strongly reducing the evidence that these asset classes have a strong positive correlation.

Gold vs. Bitcoin, May 2019 to Jan. 2021.

Regardless, gold will likely always be less volatile than Bitcoin and other crypto assets, as much of the world’s gold is physical gold and stored in vaults, making it relatively illiquid, even though a sizeable percent is tradeable through gold ETFs, certificates, and other gold derivatives. In contrast, cryptocurrencies are the most liquid of all assets, as they can be traded worldwide 24/7.

Interestingly, the growth of Bitcoin and crypto has likely reduced the demand for gold as an inflation hedge, reducing its price. In addition, typical gold investors may also be flocking to real estate instead, both in the form of traditional real estate investment trusts (REITs) as well as alternative real estate investment vehicles, such as crowdfunded offerings, which have seen particularly strong performance over the last few years.

Overall, current evidence suggests that neither gold nor Bitcoin can be strongly correlated with inflation, either conversely, or inversely.

Does Crypto Impact Inflation? A Few Theories to Consider

A far more interesting, yet far more difficult to answer question is whether Bitcoin and other cryptocurrencies can, do, or will impact inflation itself.

With the overall crypto market cap in the trillions, and the M2 money supply (amount of money circulating plus in liquid bank accounts) at around $20 trillion in the U.S. alone, it’s a difficult argument to make that crypto actually currently has a large influence on inflation– but that doesn’t mean it doesn’t have a subtle influence on the phenomenon. Plus, if the crypto market cap grows to$5-10 trillion or beyond in the coming years, it will undoubtedly have some meaningful impact on the overall monetary economics. In fact, many central bankers and economists have expressed fear that the increase in crypto use could destabilize fiat currencies like the U.S. dollar, though their fears may be premature. Below, we’ll speculate a bit about how crypto could impact inflation in the future, via four hypotheses, some of which work together, and others that may contradict each other:

1. Cryptocurrency increases inflation: Bitcoin and other digital assets increase inflation by reducing the demand, and therefore increasing the supply, of fiat currency. If the crypto market cap gets too high, holders of fiat currencies will increasingly be at risk for the devaluation of their assets. Hence, a growing crypto market cap will cause growing inflation.
2. Cryptocurrency temporarily causes deflation: As long as the crypto market cap stays below a specific, yet unknown level, crypto market cap growth will reduce inflation. This is because people use fiat money to purchase crypto, which takes money out of the economy, reducing the supply, and hence, increasing the demand for fiat dollars. It may have the opposite impact beyond a specific market cap.
3. Cryptocurrency does not have an impact on inflation: Cryptocurrency both takes money out of the economy via crypto purchases and adds money into the economy simultaneously via economic growth, meaning that the crypto market self-balances with fiat markets, neither significantly increasing nor decreasing inflation.
4. Cryptocurrency can increase or decrease inflation depending on consumer behavior: If one agrees with the hypothesis that crypto decreases inflation by reducing the supply of traditional money, inflation will increase in crypto bull markets. This is because more people are taking money out of the economy to hold or invest in crypto. In contrast, when crypto is in a bear market, people will sell it for fiat dollars, increasing the fiat money supply, and hence increasing inflation. This theory, of course, could be reversed depending on the reader’s initial hypothesis.

It’s important to keep in mind that all of the hypotheses above are highly speculative, and it may be the case that none of them end up being true.

When Looking at Crypto and Inflation, We Have More Questions Than Answers

The truth is, despite analyzing the best economic data, our understanding of the true relationship between cryptocurrency and inflation is murky at best. Past indicators seemed to support the idea that Bitcoin and other cryptos would move against inflation due to its limited supply and its mystique as an alternative asset that would protect investors against inflation.

However, recent evidence suggests that as more retail investors and institutions have invested in cryptocurrency, crypto increasingly moves with the market rather than against it. In the past, niche investors may have been more likely to hold onto their crypto assets through market crises, while today’s more conventional investors are more likely to sell off crypto assets when they begin to fall, due to the traditional market drivers of “fear and greed.”

When looking at the question of whether cryptos could actually impact inflation, the answer is even murkier. Today, the market cap of crypto is still so relatively small that any substantial impact is unlikely. However, if the overall crypto market cap substantially increases in the near future, it will likely have some impact on the global monetary system. What impact, however, is still unknown.

References

1. Cox, J. (2022, Jan.) Inflation rises 7% over the past year, highest since 1982. CNBC.
2. Garnett, A. (2022, Jan.) Why Is Bitcoin’s Price Dropping?. Investopedia.
3. Institutional Investors Not Slowing Down On Bitcoin, Here’s How Much They Own. Bitcoinist.
4. Gurdus, L. (2021, Dec.) Gold is losing its status as an inflation hedge, two traders warn. CNBC.
5. Wagner, C. (2022, Jan.) January Effect? Bitcoin Tightens Correlation with S&P 500. Blockworks.
6. Chambers, C. (2021, Aug.) Bitcoin And Gold: Something Wicked This Way Comes. Forbes.
7. Whitbourne, K, Guzman, F. (2021, May) How Much Actual Money Is There in the World?. Howstuffworks.

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