Global Rise in Inflation – Does It Affect Cryptocurrency?
When cryptocurrency was first introduced, it was meant to solve a multitude of problems that affected fiat currencies. Two of the key issues that digital currencies attempted to address were centralisation and inflation. But before we further delve into the topic, let's understand what inflation is.
What is inflation?
Inflation is an economic process that reduces the value of a fiat currency such as the dollar over a period of time. This is why the prices of goods and services continue to increase gradually. A McDonald's burger that cost you $1 a few decades ago is priced at $2 today.
According to many economists, controlled inflation works in favour of the economy. Ideally, the inflation rate should be around 2% to encourage consumer consumption. However, the current trend of inflation has gone past the point where it is directly affecting the quality of life as their purchasing power has substantially reduced in a matter of months.
With rising inflation, not only consumers don’t have enough money to spend on essentials but property prices and investments also lose their value. As consumers experience inflation, they start to invest more in goods with recurring needs in anticipation which further drives demand and causes more inflation which has a negative impact on the economy.
This is one of the reasons why it has become important for people to explore and identify alternatives that can help them guard their money against inflation.
Cryptocurrencies hedge you against inflation
The money you currently have in your savings account is losing value much quicker than it used to. It means that you need to have a financial hedge against inflation. This is where investing in cryptocurrencies can help you out.
Investors and individuals who don't want their Euros and Dollars to erode have an alternative in the form of Bitcoin, Ethereum, Ripple, and many stablecoins. There are a number of ways digital currencies are protected against inflation.
Most fiat currencies are controlled and managed by the Federal Reserve banks through a tight monetary policy. This gives a single organisation a lot of influence over the fate of fiat currencies. On the other hand, cryptocurrencies are governed in a decentralised manner where a single organisation or individual cannot exercise undue or excessive influence over digital currencies.
One of the reasons why fiat currencies fall victim to inflation is because there is no limit on minting new currency notes. Every time a bill or coin is created, the overall value of the fiat currency takes a hit. That's not the case with most cryptocurrencies as they have built artificial scarcity into the economic model with a cap on maximum supply. For instance, only 21 million BTC coins can be mined and the process becomes slower with time.
Insulated against uncertainty
Since most of the conventional asset classes such as stocks and commodities are governed and regulated by the states, social and political developments can have a major impact on their value. For example, during the COVID-19 pandemic, all financial markets crashed along with crypto but the digital currency market bounced back quickly to demonstrate its tenacity in the face of uncertainties.
Although predictable isn't what we generally associate with cryptocurrencies as they tend to be volatile, limited supply makes them predictable in different ways. You can always create new fiat currency bills and find new gold resources but the supply of BTC will still remain at 21 million tokens.
Not all cryptocurrencies protect against inflation
You have to keep in mind that while Bitcoin and many other digital currencies are built using an economic model that features restricted maximum supply and controlled circulation, not all crypto coins are created like that. Some cryptocurrencies don't have any cap on their maximum supply which means the blockchain can mint any number of coins.
Apart from that, stablecoins are also more likely to experience inflation as they are pegged to fiat currencies to counter volatility. As they are backed by a fiat currency reserve, it reduces day to day volatility but the stablecoin also loses value if the reserve currency does.
Having said that, it doesn't necessarily mean that investing in stablecoins to hedge against inflation is a poor choice. Many stablecoins provide you with a consistent interest-like income that can counter-act against inflationary pressure. This is why it is important to take different factors into account when investing in a stablecoin as a protective measure against inflation.
There is no doubt that cryptocurrencies that have a cap on maximum supply are not prone to inflation and make for a good hedge against inflation. That being said, it is crucial to weigh the pros and cons of every investment and ensure that the net result enables you to gain value.