What effect does inflation have on cryptocurrencies?

Despite the collapse of FTX and the falling Bitcoin price, is there a role for crypto as a means of protecting against loss of an investment portfolio and as a possible safe haven?

Again there is a new inflation record in the Netherlands. In September, that rate was 17%. This means that people spent an average of 17% more on their normal expenses compared to a year earlier than last year.

CBS, the Dutch statistics office, reported that inflation in the country reached record highs in September, driven primarily by rising energy costs. The consumer price index (CPI) has risen to more than 14%, compared to 12% in August. The CPI shows the price development of goods and services purchased by households in the Netherlands.

Image: CBS.

The biggest increase can be seen in energy prices. Statistics Netherlands reports that energy prices rose by 200% in September compared to the same month last year, while the price increase in August was 151%.

The relationship between inflation and cryptocurrency

Cryptocurrencies are incredibly volatile. They are sensitive to daily ups and downs. But it’s not the only thing that’s had a tumultuous time lately. Stocks around the world have collapsed. Current circumstances, such as the war in Ukraine, fears of (even higher) inflation and higher interest rates, have caused the financial markets to take a beating. In addition, the collapse of FTX has caused a decline and damage to confidence. It is therefore not only due to the high inflation, but the entire uncertain market is the cause.

What is the relationship between cryptocurrency and inflation? The two were expected to have a close relationship: as inflation rose, cryptocurrencies were expected to increase in value, resulting in the potential protection of purchasing power. But is this really the case? This doubt is becoming more common as inflation has risen at its fastest pace in decades, yet cryptocurrencies are highly volatile. Some industry observers are rethinking crypto’s function in a world of chronically high inflation. And many are now wondering what place cryptocurrencies have in a hyperinflationary society.

Cryptocurrencies are generally seen by proponents as a digital alternative to a ‘regular’ currency, and in a way this is true. While more and more crypto machines and places are starting to accept cryptocurrencies like Bitcoin and Ethereum, not all cafes are currently doing so. Still, an increasing number of well-known stores and websites now accept Bitcoin, and this trend may continue. In addition, there is a large increase in the number of crypto machines.

Image: Zippia.

Cryptocurrency as a safe haven?

In a world where money loses purchasing power over time due to inflation, investors are looking for assets that can hold their value as prices rise.

Given the potential of digital currencies in a year like 2021, some have speculated that cryptocurrencies are a good means of combating inflation. Many people already do this when investing in gold, commodities and other parts of the economy. To hedge against the volatility of the US dollar, some investors choose to put their money in crypto over traditional and alternative investments.

The instability in the form of large price swings over the past few months and the past year means that cryptocurrencies cannot keep up with inflation. For example, in 2021, when consumer inflation increased, the value of Bitcoin decreased and continued to decrease through 2021 until today. This is further proof that Bitcoin is unreliable as an anti-inflation tool. It is difficult for the average person to consider a digital currency as a reliable means of payment if its value can fluctuate by 10% in a few days. With such fluctuations in value, it remains a dangerous financial asset class and currency.

Maxim Manturov, head of investment advisory at Freedom Finance Europe, says: “Based on the results of a Bloomberg Markets Live survey of 900 investors, value stocks appear to be the most inflation-resistant with 35% of the vote. The data shows that Bitcoin, the largest cryptocurrency by market capitalization, scored a modest 4% of the total, with gold and inflation-linked bonds also lagging far behind the leaders.Choosing value stocks over Bitcoin is the latest rejection of the idea of ​​crypto as “digital gold,” a term that suggests that Bitcoin is a safe haven – similar to the precious yellow metal – in times of high inflation, market turmoil and geopolitical crises”.

Cryptocurrency Against Inflation?

Like precious metals, various cryptocurrencies are only available in a fixed number of units. For example, Bitcoin has a maximum amount of 21 million Bitcoins. The best cryptocurrencies to use to hedge against inflation are coins with a limited supply and strong acceptance. The two best cryptocurrencies to use as hedge against inflation is therefore likely to be Bitcoin and Ethereum, although you wouldn’t say so at the current price.

But a large drop in value is not always a reason to write off an investment. We have witnessed declines of this magnitude at least four times in the last decade, and despite these previous movements, cryptocurrencies are now more integrated into the financial and investment system than ever before.

Bitcoin and Ethereum have shown a huge increase in value over the long term. This year is a big setback, but it’s not a big change when you look at the longer past.

Central bank digital currency as a solution?

You have probably heard the stories about digital currencies from central banks. Currently, it is unclear whether such a currency is a replacement for cash or the existing monetary system. Even the current leader in the field, China, has not carried out nationwide trials.

There are two possible monetary policy benefits of adopting a digital coin. If a digital currency could pay negative interest and paper money was phased out, it would mean that interest rates would no longer be regulated by the zero lower limit. Therefore, the central bank can keep the interest rate as low as necessary. Additionally, if everyone had access to the central currency, no one would borrow at less than the interest rate, which would improve the central banks’ control over the interest rate.

No guarantees, but you don’t have to avoid either

Bitcoin and other cryptocurrencies are already used by some investors as a hedge against inflation. Since crypto has little history and is still in its infancy, it is not clear what this asset will do in the future. The great uncertainty makes it difficult to make reliable predictions.

Investing in cryptocurrency is therefore still risky at the moment. If Bitcoin (or any other cryptocurrency) is part of your diversified investment strategy, you should create specific goals for it. When the coin reaches a certain price, you can use it to decide what to do. In this way, you avoid acting on emotions.

About the author: Dmytro Spilka is the founder and CEO of Solvid.

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