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How Does Inflation Affect Cryptocurrencies?

Cryptocurrency and inflation are supposed, at least on paper, to be have a close relationship – the higher the inflation, the higher the price of crypto. The idea behind it is the notion that crypto would act as protection for the purchasing power of your money. However, this seems not to be the case as over the past couple of months inflation has soared at unprecedented levels not seen in decades and, in turn, crypto’s USD value has come crashing down. So what role do cryptocurrencies play in a world dominated by high inflation?

The opinions presented in this article do not in any way constitute trading, investing or financial advice.

The Relationship Between Crypto and Inflation

Cryptocurrencies have established themselves as both, a form of investment and a means of payment. Over the past years many businesses around the world are increasingly accepting cryptocurrencies like Bitcoin (BTC) or Ethereum (ETH). A lot of investors are diversifying their money, storing a sizable chunk in cryptocurrencies in hopes that it will increase in value, making it less vulnerable to the fluctuations of the U.S. dollar and other traditional assets.

And yet, over the past months, we have witnessed big swings in both the crypto market and the stock market. Both markets are lacking the consistent price-action movements needed to outpace inflation. These volatility swings of sometimes over 10% in one or the other direction in a matter of couple of days makes it even more difficult for the average investor to view such risk-on instruments as a safe heaven.

Judging by the latest inflation boom, crypto arguably is more correlated to growth/tech stocks than to commodities, such as gold or oil. However, as digital assets are such a youthful investment asset class, it is quite impossible to predict how they will transform in the future. The risk is simply less well understood and more difficult to compare with other securities.

Is This An Inflation Period Like No Other?

Looking back at the last two years, it is safe to say, that the world as a whole has gone through a lot. During the global pandemic, supply chains have been heavily disrupted, the labor force has experienced major changes, commodity prices have gone through the roof, consumers have consumed even more, many international relationships have degraded and, to top it all off, most governments have printed unprecedented amounts of fiat currency.

Back in June, the U.S. inflation rate hit a multi-decade high steaming past 9% year-over-year. This sounded alarm bells pushing the Central Bank to increase the interest rate benchmark by 75 basis points in June. And that’s after the 50 basis points raise in May and 25 basis points in March.

As a consequence, risk-on assets dropped in liquidity, causing massive price swings and a lot of volatility. The Federal Reserve is keeping a very close watch on the rate of inflation as we transition into Autumn and many are anticipating an even more aggressive response, perhaps something in the vicinity of 100 basis points.

These fears weight down on cryptocurrencies – along with tech – and most likely point to more downward pressure. However if the Fed’s aggressive approach to monetary policy continues, it might ‘break’ the credit market and, with it, the economy. Consumers are increasingly taking on more debt, which under a even higher interest rate scenario would increase the risk of defaults, bankruptcies and, in turn, reduce spending drastically, causing an economic downturn.

The Fed’s rate hikes will eventually stop and perhaps even we will witness a continuation with quantitative easing again. The cryptocurrency market will most likely recover and experience new all-time highs within a year or so, considering the strong macro environment around crypto assets.

In the short-term, the USD will probably continue to explode upwards, wreaking havoc on global markets and pushing investors to hoard their money until the Fed loosens its grip and cryptocurrency prices stabilize.

Conclusion

The transformative potential of digital currency and blockchain technology is now clearly undeniable. Crypto is very likely going to change the financial banking systems. However, whether crypto is a true inflation hedge remains to be seen.

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