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John Martin 09 Jan 2024 ◦ 8 min read

Can Crypto Still Be a Hedge Against Inflation?

Can Crypto Still Be a Hedge Against Inflation?

In recent years, there has been a growing interest in using cryptocurrency as a store of value against inflation. Inflation is the rate at which the general level of prices for goods and services rises. It can erode the purchasing power of traditional currency. Therefore, some have turned to cryptocurrency as a potential hedge against inflation.

However, the relationship between cryptocurrency and inflation is complex and subject to debate. Some experts believe that cryptocurrencies can serve as a store of value. However, the others are skeptical. In this article, we will examine crypto as a financial instrument against inflation.

What is inflation?

Inflation is defined as the growth in money supply minus the increase in the total cost of goods and services in the economy.

Imagine that you have a limited budget. Let us say that you are a student and your daily budget for meals is $10. It is 2:00, and you are heading home after school. You are hungry, and you spent $9. There is only one dollar left that you are ready to spend. It is good that on the way home there is a cheap pizzeria, and you can buy a piece of pizza for only $2! However, what if you were in the same situation the following week after a period of inflation would change your desire or opportunity to buy the same piece?

In traditional economies, central banks are responsible for increasing or decreasing the money supply, which can be seen as "printing" or "burning" money, although the Treasury is doing this. The goal of central banks is to ensure their financial stability. In most cases, this is achieved because of their ability to stabilize inflation using clear target rates or ranges. Central banks target inflation in two main ways: 

1) By buying or selling assets; 

2) By adjusting the interest rates they charge for commercial banks, all of which is called monetary policy.

Unfortunately, these instruments have a limited impact on prices and interest rates in the economy. The ability of central bank policy to influence inflation is known as a transmission mechanism that is characterized by long, variable, and uncertain time delays.

Cryptocurrencies as a Hedge Against Inflation

Proponents of cryptocurrencies cite deflationary characteristics as one of their advantages. Assets like Bitcoin do not carry inflation risks because their issuance is strictly limited. In this regard, some cryptocurrencies are considered to have the ability to protect capital from inflation caused by fiat currencies. However, experts' opinions on this issue often vary depending on their stance and attitude towards cryptocurrencies and blockchain technologies.

The cryptocurrency market is closely tied to the exchange rate of the first cryptocurrency, and Bitcoin itself has a limited supply of 21 million coins. In theory, it is possible to consider cryptocurrencies as a deflationary asset because they exclude the cause of inflation, which is a constant increase in the money supply.

However, in practice, everything is much more complicated than simply considering assets "in a vacuum," the expert warned. The value of cryptocurrencies, like any public currency, directly depends on investors' confidence in these currencies and related assets.

In the long term, global inflation has a positive impact on cryptocurrencies, as long as the reputation of cryptocurrencies remains stable. This is unlike the reputation of world currencies, which are often issued as a result of erroneous political decisions.

However, in the short term, events like the current surge in inflation have a detrimental effect on cryptocurrencies. During these moments, investors tend to shift their capital to government bonds and precious metals. As a result, there is an outflow of money, causing prices for many once-promising assets to fall noticeably.

Challenges and Criticisms Behind the Use of Crypto as a Hedge Against Inflation

Deflationary cryptocurrencies, with their fixed or decreasing supply, are often viewed as a hedge against inflation. However, they come with several challenges and risks:

  • Volatility: Deflationary cryptocurrencies can be extremely volatile, which makes them a risky option for hedging against inflation. The value of these assets can fluctuate significantly, which poses a challenge for investors looking for stability.
  • Regulatory issues: The regulatory environment for cryptocurrencies is continually changing. Deflationary cryptocurrencies must navigate this uncertain environment, which can pose risks to their long-term sustainability and adoption.
  • Low adoption rates: Despite their potential as a hedge against inflation, deflationary cryptocurrencies have lower adoption rates than traditional inflationary cryptocurrencies like Bitcoin. This lower adoption may affect their liquidity and usefulness as a hedge.
  • Limited usability: The fixed supply of deflationary cryptocurrencies can lead to hoarding and reduced circulation, impacting their effectiveness as a medium of exchange.

While deflationary cryptocurrencies offer the potential to protect against inflation, their inherent challenges and the changing regulatory environment present risks that investors should carefully consider.

If, for example, investors transfer their fiat money to cryptocurrency stablecoins (assets with a price link to fiat currency, usually the US dollar), they can still experience the adverse effects of traditional inflation. This is because the reserve value of stablecoins will decrease over time. As a result, stablecoins will have reduced purchasing power for buying goods.

Another factor that affects cryptocurrencies and inflation, as well as their ability to protect against inflation, is market uncertainty. Uncertainty in traditional markets, stemming from factors such as inflation, politics, or world events, is mirrored in the fluctuation of stock values. Furthermore, cryptocurrency markets are still influenced by price movements in the traditional market.

Thus, bearish macro trends and events, such as the "black swan" in the traditional sphere, are often mirrored in the cryptocurrency market. Since the cryptocurrency industry is still relatively small, it is also extremely volatile. This means that investors may sometimes incur losses, and the project's value may plummet to zero overnight if the community suddenly loses confidence and sells all its assets. Using cryptocurrencies to hedge against inflation can be highly lucrative, but it comes with risks. Be sure to conduct your own research before investing in any cryptocurrency platform or asset.

Future Prospects: Will Cryptocurrencies Protect the World From Inflation?

Bitcoin and other deflationary cryptocurrencies created to store value and protect against inflation are not only new technologies based on blockchain and consensus mechanisms but also allow a wider experiment: transferring long-term storage of value to a figure, instead of physical carriers (precious metals and stones).

The ability of cryptocurrencies to program emissions at preset values​ is an important experiment with value and money supply. The inflation or deflation rates may be set in advance. This allows one to build a predictable monetary system and make financial decisions based on a specific value.

However, the positioning of cryptocurrency as a value store raises the question of whether it can function simultaneously as a means of exchange. Currencies should be stable simply because the interacting parties do not want to face risks due to price fluctuations at the time of the transaction. Because bitcoin is volatile today, it is not the optimal means for exchanging value​ in everyday transactions. Fiats are doing great with this, but the long-term prospects are worse.

Conclusion

The discussion on cryptocurrencies and inflation can be confusing. However, we hope that you understand the different definitions of this word in the industry. In addition, when considering the question "Do cryptocurrencies protect against inflation?" we advise readers to exercise due diligence when considering a model for distributing the tokens of a particular project.

Turning to cryptocurrencies as a short-term capital protection tool in times of high market uncertainty can be risky and short-sighted. However, if cryptocurrencies are valued over a longer planning horizon of 5 years or more, the value of these assets will likely grow enough to outpace global inflation. 

Now, it is difficult to predict what might happen to cryptocurrencies over such a long period of time, because even a scenario of complete compromise for this asset class, with its almost total devaluation, cannot be ruled out.

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