Inflation and Crypto Market — Is it related?
Cryptocurrency has been introduced in the market for over 10 years and has been gaining attention and growing consistently. However, starting since 2021 and up until 2022, our economy has experienced a strong inflation pressure and is the era where consumer price hikes.
There are several discussions whether there is a correlation between strong inflation and the plunge in crypto market. In this article, we will explore what are some of the relationships between inflation and crypto market performance.
Current inflation situation in 2021–2022 world economy has been hitting a 40-year-high. On the other hand, crypto market has lost 2/3 of its value. Major coins such as BTC has been experienced shifts in its value.
There is a belief that cryptocurrency is a counter-inflationary asset as it is different from foreign currency. The value of foreign currency responds to inflationary pressures. On the flip side, some people do believe that value of crypto assets will increase as the value of money decreases since people will seek out for a better place to store value when local currency inflates. For instance, as dollar values weakened, people would want to cash in BTC to preserve spending power. This would make crypto asset more valuable.
Classes of crypto assets
Let’s take a step back. According to the U.S. Securities and Exchange Commission (SEC), crypto assets falls into 2 investment classes: commodities and securities. These classes makes cryptocurrency not really a currency as it does not behave like currency.
Crypto assets such as Bitcoin (BTC) are classified as commodities as they have the same principles as gold. This type of asset has a pre-determined quantity and nature. Nothing can change the nature of this type of asset.
Crypto assets such as utility tokens or stable coins are classified as securities as they share the same principles as securitized assets such as stocks as bonds. These assets are generated as underlying project sees fit in the market. Enterprises create tokens, sells them on open market, and create new tokens or eliminate the existing ones. Nature of these crypto tokens are defined by the nature of underlying project, which holds the same principle as share of stocks.
How do commodities and securities perform in a high inflationary era?
Government’s tool to manage inflation is to adjust interest rates. As interest rate decreases, people are encouraged to borrow money as it is cheap. People would have lesser incentive to save; therefore, people choose to spend instead. In contrast, as interest rate increases, the cost of borrowing money is higher. The incentive to save money is higher than to spend. Therefore, consumers and business are put off from spending and borrowing.
With inflation, the Federal reserve have adjusted interest rates to be higher. Lenders would demand a high interest rate as a compensation for lower purchasing power of money paid in the future.
In the era of cheap money and high liquidity, it is easier to invest in high risk assets (i.e., crypto) as investors have lots of money but few better alternatives. However, during recession, investors will seek out for stability by pulling money off from crypto, which drags down the price of crypto and other capital gain oriented assets during the inflation era.
Why is it important to know?
As we all are a part of this economic situation, it is beneficial to understand the basic concept of how assets get affected and how market reacts to increase in interest rates during inflation. We can then prepare a plan to handle and manage our assets during this situation.
— 3percent team
