Cryptocurrency And Inflation: How Does It Affect Your Investments?

If you have been paying attention to the news, you’ll know one of the biggest stories right now is record-setting inflation, with each month bringing a more eye-popping rise in prices. But how do cryptocurrencies fit into this narrative? Some investors see certain cryptocurrencies as a hedge against inflation, similar to gold. Others view cryptocurrencies as riskier assets whose price volatility makes them unattractive in challenging economic times. Below we attempt to answer some of the most common questions about cryptocurrencies and inflation.

How does inflation affect bitcoin?

Bitcoin is the largest cryptocurrency by market cap and arguably the most well known. As inflation rises, the U.S. Federal Reserve (the Fed) and other major central banks may be inclined to continue to raise interest rates or tighten monetary policies to slow the price rises. As a result, many asset classes, including cryptocurrencies, may see their prices fall.1

Do cryptocurrencies experience inflation?

Yes, cryptocurrencies may experience inflation. Different cryptocurrencies have different monetary policies, and thus may be subject to different rates of monetary inflation. Stablecoins are a type of cryptocurrency that seeks to peg its value to fiat money, and thus their value is directly affected by the monetary inflation of the fiat currencies to which they are pegged.

A cryptocurrency is inflationary when its supply is increasing over time. New tokens may be introduced into the system through mining or staking rewards. As the supply of tokens increases, the value of any individual token decreases. All else being equal, this means that you would have to spend more tokens to buy a particular thing.

With deflationary cryptocurrencies, the supply of coins decreases over time. This means the value of each coin should rise as long as demand for them stays consistent. Take Ethereum. Its native token ether remains an inflationary coin. However, an update in 2021 resulted in some ethers being destroyed when network activity rises. After Ethereum makes the transition to proof-of-stake consensus, it is expected to be non-inflationary or even deflationary in the future.

Is bitcoin deflationary or inflationary?

Bitcoin is currently inflationary. The total supply of bitcoin increases as more of it is mined. Every four years, the rate at which new bitcoin is issued is reduced by half. In addition, the supply of bitcoin is hard-capped at 21 million. However, according to the current algorithm, this threshold won’t be reached until the year 2140.

Is bitcoin inflation proof?

Over the past year, bitcoin hasn’t really acted as an inflation hedge, according to a report by Bank of America.2 In recent months, bitcoin returns have become more correlated with those of broad stock market indexes. This means that when markets tumble, the price of bitcoin tends to fall too. For example, after the Fed indicated that it would raise interest rates in early May, bitcoin plummeted in value alongside stocks. Bitcoin has been compared to gold, which is generally seen as an inflation hedge. However, the correlation between bitcoin and gold has been close to zero since June, meaning bitcoin’s price hasn’t moved together with the gold price.3

How does inflation in fiat money affect cryptocurrencies?

A high inflation rate for fiat currencies might lead people to invest more in crypto, because the Canadian dollars or U.S. dollars in their savings accounts are losing value over time. Meanwhile, certain cryptocurrencies like bitcoin or ether may have relatively lower monetary inflation rates. Unlike fiat currencies, the monetary inflation of bitcoin is algorithmically predetermined. The hard-cap supply limit of bitcoin also makes it predictably scarce.

What happens to bitcoin after all 21 million tokens are mined?

According to the current algorithm, no new bitcoin will be created thereafter. Bitcoin miners may continue to have incentive to mine blocks, as they will still get to collect transaction fees.

What happens to the value of bitcoin in a recession?

Bitcoin prices initially fell moderately during the COVID-19-induced stock market downturn that began in February 2020 and lasted through April. However, starting in October of that year, bitcoin prices started to rise dramatically and eventually shot to an all-time high.4 Investors started taking the largest cryptocurrency by market capitalization seriously.

But if analysts are right, and the U.S. economy is bound to go into another recession as early as next year, the cryptocurrency market could see a very different outcome this time. Because of bitcoin’s recent strong correlation to U.S. stocks, the largest cryptocurrency’s performance will likely depend on what broader markets do, according to some analysts.5

Bottom line

Bitcoin and other cryptocurrencies have been touted as a hedge or safeguard against inflation. But in recent years, bitcoin has started move in tandem with other major asset classes such as stocks. When central banks and governments take action to combat inflation, most assets are adversely affected and can lose their value, and of late many cryptocurrencies have been no exception. That said, some cryptocurrencies, like bitcoin, have attributes that should make them more immune to inflation over the long term, including scarcity, ease of transfer and immunity from direct influence by governments. Cryptocurrencies can provide diversification to your investment portfolio, but it’s important to avoid owning too much of any particular asset class.