Many cryptocurrencies have long been professed as a hedge against inflation for investors. With global inflation spiking to the highest levels in a generation we re-examine the merits of this argument.
Earlier this week The Bank of England announced that UK inflation had jumped to 5.4% – the highest level since 1992. Similar rates of inflation rates are being observed globally; The United States (7%), Russia (8.4%) and Germany (5.3%). The UK Government’s target rate of inflation of just 2% is being significantly exceeded which, in turn, will likely lead to further increases in interest rates, an acceleration in falling real living standards and a detrimental impact to consumer confidence.
A perfect storm as we depart from a lower for longer interest rate environment in the wake of Covid-19. For many, largely debt-fuelled economies, this may even lead to more frequent crises.
Record inflation may already be waning
Despite The OECD forecasting inflation rate reductions later in 2022 and through in to 2023 many investors are being forced to act now. If such potential money managers had not already had their heads turned by crypto then this inflation hike may prove to be the final straw.
Driven by the Covid-19 response, increased historical quantitative easing by central banks and rising energy costs – these have all combined to propel this rapid increase in inflation, specifically known as CPI, or the Consumer Price Index.
Next generation currency to the rescue?
In contrast to the limitless supply fiat currencies since departing from the gold standard, cryptocurrencies are oftentimes fixed in their supply. Furthermore, where global fiat currencies are managed by central banks, governments, currencies boards and even monarchs, cryptocurrencies are prespecified by their creators in a document known as a white paper. The battle between old and new currencies is, therefore, arguably between the people and traditional institutions of incumbent power versus mathematics and code, respectively.
Turning to the leader of the pack – Bitcoin
There are presently just under 19 million Bitcoins in circulation, with an eventual limit of 21 million. This limit was chosen by the creator, Satoshi Nakamoto. Some analysts argue that this limited supply by design promotes scarcity and supply-side certainty thereby attracting new money looking for safe harbour in times of higher inflation. However, such ‘safety’ is relative and should be traded-off against the other risk parameters of holding cryptocurrency including price volatility, regulation and potential fraud.
Given the decentralised infrastructure of Bitcoin it is also possible that the coveted original 21 million cap can be changed in the future. But, any such modification, is only possible by consensus of the community leading to interoperability only for those that agree. See the case study of Bitcoin Cash (BCH) along with other such forks where the original protocols of the Bitcoin network were amended.
It’s not all about Bitcoin – enter Ethereum
Cryptocurrencies are typically fixed in their supply as specified in their aforementioned original white paper’s, as opposed to the technically unlimited supply of fiat currencies. Nonetheless, leading alt coins such as Ethereum are similarly unlimited in supply, albeit only with an infinite amount of time. Ethereum does exhibit inflation but the amount of Ethereum burned now outpaces the creation of new tokens.
The net effect being one of deflation leading researchers to claim that Ethereum is a superior hedge against inflation compared to Bitcoin. Notwithstanding this outcome, post the initial phases of the Ethereum 2.0 upgrade in 2020, much of Ethereum’s future success is inextricably linked with network access and perhaps most importantly the drive for lower gas fees.
Good as gold…
The comparison of crypto with gold is commonplace and, therefore, its potential merits as a hedge against inflation is unsurprising. But, the evidence, so far at least, suggests that cryptocurrencies are at best, ‘an imperfect hedge against inflation’. Investor motivation appears to still largely be speculative in nature as a security for future capital gain.
Notwithstanding cryptocurrencies as a consideration, what percentage allocation is appropriate even if an investor decided to take the plunge as inflation continues to spiral? The consensus is 2% to 5% of liquid assets. I would echo such portfolio strategies and would caution against leverage which can regularly exceed 50 times in the digital assets space.
As we adjust to the new post pandemic normal, many central banks are now looking to reign in quantitative easing and reduce the size of their balance sheets. “Quantitative tightening” may already be here according to Reuters but that will take time to dampen inflation and may be too late to prevent the ever-increasing number of new cryptocurrency adopters. In fact, the number of active Bitcoin addresses continues to climb back towards one million following the 2021 plunge caused by China legislating to ban cryptocurrencies.
Increasing cryptocurrency adoption is certainly not inevitable but higher levels of current inflation is a friend to those looking to onboard newbies. There is some validity in looking at cryptocurrency to mitigate the threat of inflation but be sure to do your homework first. As always, caveat emptor.
Gavin Brown is an Associate Professor in Financial Technology at The University of Liverpool.