How does inflation impact digital assets like Bitcoin and Ethereum?

 

Digital currencies are attractive to investors for several reasons. For some, they are a quick way to earn money, while for others, it is the belief in decentralized finance and blockchain technology. For some, investing in crypto could be seen as a portfolio diversification strategy or investing primarily due to FOMO.

All the above reasons aside, what made Cryptocurrencies – such as – Bitcoin and Ethereum appealing in the first place is the idea that they are resistant to inflation and have been popularly called inflation hedges and a store of value. The result is potential protection for the buying power of the money.

But what is inflation? And how does the rise in inflation affect cryptocurrencies?

What is Inflation?

In simple terms, inflation is the rise in prices of consumer goods which leads to a decrease in the purchasing power of the currency, like the US dollar. Economists believe that a healthy level of inflation helps the economy to grow.

Bitcoin, in contrast, has increased in value much faster than the U.S. dollar has lost its value – going from almost zero in 2010 to $20,000 in late 2020. Bitcoin has seen dramatic spikes and declines due to its high volatility, but the general trendline has been upward. This has made Bitcoin an increasingly popular hedging instrument against currency inflation.

Bitcoin is designed to fight inflation due to its known and limited supply, and since there will only ever be 21 million bitcoin, and every four years the number of bitcoins mined is reduced in half, the creation of new bitcoin will taper off over time in a predictable way. 

High inflation rates for fiat money may lead to more investments in digital currencies to assuage fears over their fiat losing value over time. Cryptocurrencies like BTC and Ether (ETH) provide a great alternative to investors who want to diversify their investment portfolios.

Cryptocurrency and Inflation

For the majority part of Bitcoin existence, its prices have not reacted negatively to interest rate hikes, rising inflation and other policy shocks due to the idea of Bitcoin’s independence from the government. Over the last few decades, inflation has reduced 85% of the value of the U.S. dollar which has strengthened Bitcoin’s notion of an alternative to fiat currency. However, bearish market conditions and socio-political scenarios have played a crucial role in determining Bitcoin’s price trajectory over the last few months.

In the post-pandemic era, the U.S. dollar’s purchasing power against Bitcoin has fallen, taking a huge dip in March 2020, followed by another dip at the end of 2020. Furthermore, the U.S. dollar’s value has further dropped due to the government’s rigorous money printing.

In November 2021, after its all-time high of $69,000, Bitcoin’s price started to decline, at the same time, the U.S. dollar’s purchasing power against Bitcoin started to rise. The U.S. dollar’s purchasing power has been on an upward trajectory for most of the year. This puts the Bitcoin narrative of inflation hedge at a huge risk. Additionally, the constant issue of market volatility and the high price of a single unit of Bitcoin poses friction for newcomer investors.

Bitcoin’s value has dropped by 57.02% from its all-time high price of $69000. In May, Bitcoin (BTC) and Ethereum (ETH) rallied on the announcement of a 0.5% interest rate spike by the FED, rising about 3.5% and 1.2% respectively.  While these digital assets saw a short-term price spike, the price rally couldn’t sustain. Many observers still believe that cryptocurrencies have been reacting similarly to the equity market.