How can inflation impact cryptocurrencies?

While inflation is never far from the thoughts of many economists, government policymakers, and individuals concerned with keeping their budget under control, for crypto enthusiasts, the relationship is a little bit more ambiguous.

This is not to say that those investing in cryptocurrencies will never have to worry about inflationary forces in the global economy – in fact, quite the opposite is true. Rather, it is that there is still quite a lot that we don’t fully understand about the relationship between the two.

For cryptocurrency enthusiasts looking to grow their investment portfolios, however, this is not a desirable position to be in. Given the ubiquity of inflationary pressures in the global economy, it is inevitable that at some point – just like investors in every other sector – you think about it when drawing up and executing an investment strategy.

With this in mind, in this short article, we will give an overview of what inflation actually is and how it impacts both the economy as a whole and individual investors, as well as its potential impact on the cryptocurrency space. It is hoped that by having a better handle on what it is and how to react to it, you can protect your crypto portfolio and put yourself in a better position to take advantage of any future investment opportunities.

What is inflation?

At its most basic, ‘inflation’ is the term that economists use to describe decreases in the value of a currency relative to the value of any goods or services you might purchase with that currency. In this sense, inflation is most often used to refer to a loss of purchasing power over time in a given economy – most often expressed as a percentage.

While a certain amount of inflation is inevitable in any healthy economy, if it rises too high or too quickly, this typically gives economists cause for concern. This is because high rates of inflation signal some underlying dysfunction in the economy – typically where basic consumer goods are priced too high relative to average wages.

However, we must also note that inflation can be viewed both negatively, as above, and positively. This will typically depend on the perspective from which it is viewed.

For example, individuals with tangible assets such as property or certain commodities may view inflation as a force that increases the value of their assets.

What causes inflation?

Although the precise roots of inflationary pressures will always differ depending on the context, there are generally a number of different causes that are understood as increasing rates of inflation. Underlying all of these is an increase in the supply of money – i.e., currency – which lowers its value.

Money supply is typically increased by:

• Central banks or governments printing more money or giving it directly to citizens.
• Taking actions to devalue the official value of a currency.
• Pumping money into the economy by issuing loans through the central banking system.

The other factors that economists look at when figuring out how money loses purchasing power are demand-pull inflation, cost-push inflation, and built-in inflation:

• Demand-pull inflation: occurs when demand for goods and services exceeds current production capacity.
• Cost-push inflation: when production costs push up prices.
• Built-in inflation: when prices of basic goods rise, this causes wage rises to maintain living costs.

But what is the impact of these forces on the world of cryptocurrencies?

Cryptocurrencies and inflation: what do we know?

Although cryptocurrencies have been around for a little over a decade, there is still quite a lot that we don’t know when it comes to understanding their relationship with inflation.

Most immediately, we have not seen how the crypto markets have reacted, as during the last decade, the global economy as a whole has experienced relatively little inflation. In this sense, no traders, analysts or enthusiasts have ever traded or invested in cryptocurrencies during an era of notable consumer price increases.

When rate rises were announced by certain central banks in an attempt to curb the flow of money in early 2022, both Bitcoin (BTC) and Ethereum (ETH) prices experienced a brief rally. This came off the back of a prolonged downward spell for cryptocurrency prices.

However, these gains were short-lived. Prices did not continue to rise or to even hold at these rates. This caused many crypto price-watchers to wonder whether the relationship between cryptocurrencies and inflation was more complex than we might initially have thought.

Are cryptocurrencies more like big-tech stocks when it comes to inflation?

In light of all these unknowns, many market-watchers have taken the position that cryptocurrencies should be thought of more like big-tech stocks when it comes to inflation.

This means that during periods of high inflation, investors will tend to shift their money away from tech stocks towards more traditional or so-called ‘safe-haven’ investments. In previous years, high-growth and tech stocks have tended to lag when inflation rises – though they have not necessarily tanked in value.

However, it could be argued that the comparison to tech stocks is limited given that cryptocurrencies are their own unique asset class. In fact, this has been all but confirmed by the likes of the IRS and the SEC in America, which have classified cryptocurrencies as either commodities or securities.

In this sense, while certain cryptocurrencies may function more like a stock, others will hold value more like a commodity. So, how does this understanding impact the way that we should view cryptocurrencies during inflationary periods?

Inflation, interest rates and investment stability

Regardless of whether we view cryptocurrencies more like a commodity or a security, what we do know is that during periods of inflation – particularly prolonged periods – central banks and governments will nearly always raise interest rates in response.

By raising interest rates, central banks and other government powers can control the flow of money into the economy, which, it is generally believed, will have the effect of increasing its value as there is simply less of it around.

The effect of this is that borrowing rates will decrease and investors will get more cautious with how any available funds are invested. For this reason, we tend to see a shift away from riskier investments during periods of inflation.

On the one hand, this might see certain investors move from cryptocurrencies – as a much younger asset class – towards more stable asset classes.

While this might not necessarily signal a widespread sell-off in the crypto community, it may push investors to focus on more established, stable cryptocurrencies.

Ultimately, however, there is still much that we don’t know about how this relationship will evolve, and it is likely that it will change as the technology underpinning cryptocurrencies develops and they assume a bigger role in the global economy.