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What Is Inflation and Its impact On Cryptocurrency?

One feature that has attracted investors to cryptocurrencies, particularly Bitcoin, is that they are more resistant to inflation than fiat currencies such as the US dollar.

What Is Inflation?

Inflation is the process by which currencies lose their value over time, causing consumer goods prices to rise. Because most economists believe that some level of inflation is beneficial to the economy, the United States government, for example, has printed more money than consumers require for decades. It’s why a Coke that cost a nickel a half-century ago now costs a few dollars.

On the other hand, Bitcoin has generally increased in value much faster than the US dollar has decreased in value, rising from nearly worthless in 2010 to more than $20,000 in late 2020. (Because it is a volatile market, Bitcoin has seen dramatic spikes and drops, but the trendline has been upward over time.) As a result, Bitcoin has become an increasingly popular hedge against fiat currency inflation.

The main way Bitcoin is designed to resist inflation is that its supply is limited and known, and the creation of new bitcoin will taper off in a predictable manner over time. (There will only ever be 21 million bitcoin, and the amount mined is reduced by half every four years.)

Why Is Inflation Important In Cryptocurrency?

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A high rate of inflation for fiat currencies may lead individuals to invest more in digital money because the dollars or Euros they place in a savings account lose value over time. Bitcoin and other cryptocurrencies, such as Ethereum, provide an alternative for investors. The Bitcoin market’s economics are complex, but there are some features built into the digital currency that may help it resist inflation.

  • Governments can’t manipulate Bitcoin by changing interest rates or printing more money to achieve policy goals.
  • According to conventional wisdom, Bitcoin, like gold and other scarce stores of value, is expected to rise in price during uncertain times. (This has not always been the case; for example, it fell sharply alongside the stock market at the start of the COVID pandemic.) It’s also a much more convenient way to store and transmit value than gold because it can be sent via the internet. 
  • Scarcity is one of the keys to creating an inflation-resistant store of value. There will never be more than 21 million bitcoin in existence. Approximately 19 million bitcoins have been mined as of now. Miners process a new “block” every ten minutes, and 6.25 bitcoins are added to the network. (By 2024, the mining reward will have fallen to 3.125 bitcoin and will fall by half every four years until all bitcoins have been mined. This mechanism is known as the halving, and it is built into the Bitcoin protocol.)
  • This planned tapering of new supply over time makes Bitcoin unique in that no new bitcoin can ever be “discovered” — unlike gold; no new bitcoin can ever be “discovered.”

Do Cryptocurrencies Experience Inflation?

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Yes, Bitcoin experiences inflation as more of it is mined (as does gold). However, Bitcoin’s inflation rate will fall because the supply of new bitcoin is automatically reduced by half every four years.

In practice, as long as Bitcoin’s purchasing power continues to rise relative to the fiat currencies to which it is commonly compared, Bitcoin’s 1% annual rate of inflation isn’t a major factor for investors to consider.

However, not all cryptocurrencies are designed in the same way as Bitcoin. For example, a growing category of digital money known as stable coins, many of which are pegged to fiat currencies such as the dollar, can be a useful, low-volatility place to save some money. However, if a stable coin is pegged to a fiat currency, your investment will be affected by inflation and may lose value over time as their reserve currency depreciates. (Some stablecoins provide rewards similar to an interest-bearing savings account, which could alter the value equation (especially with non-crypto interest rates hovering around zero).

What Kinds of Cryptocurrency Can Be Inflation Hedges?

Many cryptocurrencies, like precious metals, have a finite supply that cannot be changed. Beyond the storage of value, the advancement of advanced crypto-financial functions has resulted in novel ways to put your savings to use.

Staking, yield farming, and lending platforms are rapidly expanding crypto industries that allow you to put your coins forward to provide crypto services that can passively grow your savings. Some currencies burn coins as they are exchanged in order to deflate their supply and incentivise coin ownership. All of these functions come with different risks that should be considered when building a strong crypto portfolio.

Due to the fact that the blockchain industry is still in its early stages, cryptocurrency prices can be quite volatile. While this may not be the best way to store value in the short term, prices will rise in the long run if demand for cryptocurrency continues to rise. Because a coin’s economics are written in code and stored on the blockchain, no entity can print more bitcoin in the future.

The best cryptocurrencies to hedge against inflation are those with a limited supply and widespread adoption. Bitcoin and Ethereum are likely the two best cryptocurrencies to use as a hedge against inflation.

Bitcoin’s Potential As An Inflation Hedge

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One of Bitcoin’s major advantages over other cryptocurrencies – and even fiat currencies like the US dollar – is that it is said to hedge against inflation over time.

Bitcoin tokens, unlike other currencies, have a limited supply. There will only ever be 21 million tokens in circulation, and current estimates indicate that we will reach that limit around 2140. Because there is a limited supply of tokens, Bitcoin’s value should theoretically hold up over time.

Gold has traditionally been regarded as the most effective inflation hedge. The supply of gold remains relatively stable over time, and gold has an inverse relationship with inflation: as inflation rises and the US dollar loses purchasing power, the value of gold rises.

However, as inflation has risen in recent months, gold has underperformed. While everything from housing prices to gasoline prices to energy costs has risen, the price of gold has fallen in the last year.

On the other hand, Bitcoin has seen its price continue to rise as inflation continues to rise. As a result, Bitcoin appears to be a more effective inflation hedge than gold. However, there are other factors to consider that may have an impact on Bitcoin’s long-term inflation hedge potential.

How Will Bitcoin Fare Over The Long Run?

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Although Bitcoin has had a fantastic year and has managed to hedge against inflation in recent months, it is too early to predict how it will fare over the long term.

Bitcoin has only been around since 2009, whereas gold has been around for centuries. With such a short track record, it’s difficult to predict whether Bitcoin will have the same longevity as gold.

Furthermore, while gold is widely regarded as an inflation hedge, many people remain sceptical of Bitcoin in general. Everyone does not share its potential, and it remains a speculative investment at this time. If the general public refuses to accept Bitcoin (or cryptocurrency in general), it is unlikely to survive in the long run).

Bitcoin is also extremely volatile, which may limit its usefulness as an inflation hedge. Aside from inflation, there are numerous factors that can influence the price of Bitcoin, and several forces may be at work when it comes to its recent price increase.

In short, no one knows how Bitcoin will fare as an inflation hedge over time. While it appears promising right now, only time will tell if it continues to perform well in the long run.

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