Crypto enthusiasts often talk about bitcoin as a hedge against inflation. Why?
The argument is that central bank money printing will lead to inflation or the decrease in the value of money over time. Bitcoin, by contrast, has a fixed limit of 21 million coins that can ever be created. This limited supply allows bitcoin to resist inflation.
The COVID-19 pandemic presented the ideal conditions to test this theory once countries across the world began injecting trillions of dollars into their economies. Many countries, including the U.S., printed money to meet stimulus requirements for its citizens.
Yesterday, the chairman of the U.S. Federal Reserve, Jerome Powell said the central bank welcomes higher inflation in 2021 as a sign that the economy is picking up again after the pandemic-slump.
Governments hoped an expansionary monetary policy, whereby central banks increased the amount of money available to people, would keep economies moving amid prolonged shutdowns of certain sections of the economy. By June 2020, stimulus action taken by countries had surpassed $10 trillion, according to a McKinsey Global report. U.S. government-spending alone amounted to $6.5 trillion in 2020, up 48% from the previous year.
Theres a crazy amount of money being printed right now, so the value of money is going down. Assets with limited supply, like bitcoin, real estate or shares/stocks, those price tags are going up, Oki Matsumoto, CEO of Monex Group told CoinDesk.
Its true that despite dramatic drops in global economic output and unemployment, market jitters drove asset prices up: the stock market ended the year with record gains. Even bitcoin, considered a fringe asset, had a historic price run, gaining more than 250% by the end of 2020.
These gains were partly influenced by traditional investors who saw bitcoins potential to work as a hedge against inflation.
And yet, the kind of inflation investors were expecting isnt here, at least not yet. In fact, U.S. inflation remained stable through 2020. Some economists dont believe that inflation in America will be running rampant any time soon. Others think a little post-pandemic inflation might even be a good thing.
What is inflation, anyway?
It depends on whom you ask.
The U.S. Federal Reserve defines inflation as the increase in the price of goods and services over time, but many associate it with a change in the money supply, or the total amount of money in circulation.
In the bitcoin world, they dont use the term inflation quite the way that economists do, as a general increase in consumer price. Instead, they tend to use it to mean an increase in the money supply, said economist and CoinDesk columnist Frances Coppola.
The crypto argument that printing more money leads to inflation does sound compelling, Michael Ashton, inflation consultant and JPMorgan alum, told CoinDesk. When there is a change in the relative quantity of two goods, the one that is increasing in quantity tends to get cheaper, he said, adding that this happens with foreign exchange all the time.
The reason why the Mexican peso has been cheap relative to the U.S. dollar for a long time is because the supply of Mexican Pesos has consistently outpaced the supply of U.S. dollars, Ashton said. Because here are a lot more pesos than dollars out there, he explained, the value of the peso in exchange markets goes down.
Thats part of the crypto argument. They say, Were gonna limit how fast cryptocurrency supply can grow and since we are printing all these dollars, then that means that the dollar has to depreciate a lot relative to crypto. Therefore, the price of crypto should rise over time, Ashton said.
Calvo said the view that you can control the price levels of goods and services through money supply is not limited to the crypto world but shared by investors in general, and for good reason. When you look at many countries over a long period of time, you can see some association between the increase in money supply and inflation, Calvo added.
But Calvo, Coppola and Ashton all agree that increasing the amount of money in the economy with a stimulus package, for example does not guarantee a rise in price levels.
If you increase your money supply, you may or may not get an increase in the consumer price level depending on what else is going on in the economy at the time. So there are a number of other factors to consider, Coppola said.
Money is printing, is inflation soaring?
Not really, at least in the U.S.
The U.S. Federal Reserve has an inflation target of 2% measured using the consumer price index (CPI). In 2020, despite inflationary fears due to pandemic-related spending, the U.S. inflation rate hovered around 1.5%, well below target.
One explanation for the relative stability of U.S. inflation is money velocity, which quantifies how fast money changes hands in an economy. If the money supply is increased, but people dont spend a lot of money quickly, inflation can remain in balance.
After the pandemic hit, consumer spending suffered around the world, with countries including the U.S., India, Japan and Germany reporting large drops in household spending. As multiple states in the U.S. went under lockdown, people stayed home instead of dining out, celebrations and gatherings stopped, and travel came to a screeching halt.
People spending less meant the demand for goods and services in general had dropped. Global energy demand declined 6% in the first few months of 2020, its biggest drop since World War II, according to the international energy agency (IEA).
Weaker demand and significantly lower oil prices are holding down consumer price inflation, the Federal Reserve wrote in its June 2020 monetary policy report.
The World Bank, in fact, projected a fall in global commodity prices.
It is under these prevailing conditions that the U.S. government was distributing stimulus funds.
So people are accumulating money, but it is not reflected in the price level, Calvo said.
Ashton explained this may be because money velocity is very low. People are not getting rid of U.S. dollars fast enough, so the price levels dont increase dramatically.
When you drop a ton of money into peoples bank accounts, they cant spend it instantly. So, mathematically, you have to have a declining money velocity. Thats what happened, Ashton said.
What about outside the U.S.?
American inflationary fears may be in part due to whats happening in other parts of the world. Some investors may be looking at countries like Argentina and Venezuela where printing money has led to very high inflation.
What investors are doing, in general, is looking ahead and saying, were seeing a lot of money going into the economy. Therefore, there is a risk that it could happen in the United States; therefore, we need to invest in things that will protect us from that inflation, if it happens. Thats the conventional inflation is coming, we need to protect against it argument, Coppola said.
But in the countries they are looking at, things work differently, Coppola added.
Venezuela and Argentina are hyperinflationary economies where price levels grow rapidly and excessively triggered by an increase in the money supply or a shortage in supply relative to demand.
In Venezuela, for instance, printing money led to jaw dropping increases in food prices last year. The international monetary fund (IMF) reported that the inflation rate in Venezuela was a whopping 6500% in 2020.
In hyperinflationary countries, years of political and economic instability have exhausted the option of printing money without leading to uncontrollable inflation, Calvo said. Coppola added that countries struggling with hyperinflation have other contributing issues like high foreign exchange debt, war, occupation or something political.
Argentina, for example, has had a long and complicated economic crisis riddled with astronomical debt obligations and political instability that often has citizens scrambling to convert their Argentine pesos into sturdier assets or currencies.
In Argentina, the minute [the government] starts increasing the money supply, very quickly, you see the consequences in the price level, Calvo said, adding, Some countries have the privilege of printing money if necessary. Nothing happens. Argentina doesnt have that privilege.
Interestingly, the pandemic has not particularly spurred inflation in Argentina either. By mid-2020, inflation in Argentina had reached a two-year-low, according to a Focus Economics report.
Because Argentines were also under lockdown during the pandemic, the slowed economy and low demand combined with increases in government spending hasnt caused a major rise in price levels, Calvo said.
If inflation isnt soaring, why are people hedging against it?
People may be buying bitcoin as a hedge against future inflation, and theyre not crazy to do so.
According to a statement made to the media by Federal Reserve Vice Chair Richard Carida, the Federal Reserve will continue to maintain near zero interest rates until inflation rises enough to meet its 2% target.
U.S. policy makers know exactly what theyre doing, said Phillip Gillespie, chief executive officer of crypto liquidity provider B2C2 Japan.
They are basically going to suppress the interest rates and let inflation run higher, Gillespie told CoinDesk.
But economists are saying that as the country reopens and spending picks up, reining in price levels to maintain the inflation target will be one of the biggest challenges in the Federal Reserves 108-year history.
So naturally, investors are reacting to all the inflation doom and gloom by betting against it, turning an alternative asset like bitcoin into the 2020 breakout star of inflation hedging in the process.
Bitcoin inherited a lot of the same selling points that made gold a preferred inflation hedge like scarcity and portability, according to J.P. Koning, Canadian financial writer and founder of the popular blog Moneyness.
But when it comes to serving as a hedge against inflation, bitcoin is hardly alone.
If you look around your house, everything is an inflation hedge, Koning said. Your house itself is an inflation hedge, your table, your personal capital, your education are all inflation hedges because all of those things will rise in value as the purchasing power of the currency falls.
The rest is here:
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