Bitcoin vs inflation: embracing scarcity in a fiat world

If one theme has dominated the global financial markets lately, it’s inflation. After barely exceeding 2% in most developed countries over the last ten years, prices soared in 2022 following several rounds of quantitative easing and disruption to supply chains caused by the covid pandemic and the war in Ukraine.

Investors have traditionally turned to gold as a hedge against inflation because it exhibits characteristics which make it an effective store of value. As bitcoin shares many of these characteristics, it’s sometimes referred to as digital gold .

This article explores the forces driving inflation and whether bitcoin can serve as a hedge against it.

Inflation and its Causes

Inflation is a term used to describe a rise in prices, typically triggered by an increase in an economy’s money supply. It’s measured by tracking price changes of a basket of goods and services used by consumers, usually known as the Consumer Price Index (or some variation).

One way to increase the money supply, especially when a country’s interest rates are already near zero, is through quantitative easing (QE). QE involves central banks purchasing securities on the open market- mostly government or corporate bonds. Buying bonds pushes up their price, and because price move inversely to the interest rate they pay, long-term rates drop. By lowering the cost of borrowing and discouraging saving, QE puts more money into the hands of consumers, which stimulates economic growth.



QE was first employed by the Bank of Japan in 2001, but it became widely adopted during the 2008 financial crisis:

• 2008- 2010: The Federal Reserve purchased over $1.7 trillion of bonds and mortgage-backed securities (MBS).

• 2009-2012: The Bank of England spent £200 billion on government and corporate bonds

• 2015-2018: The European Central Bank (ECB) bought €2.6 trillion of government and corporate bonds and MBS

All three central banks launched new rounds of QE (labelled the Pandemic Emergency Purchase Programme by the ECB) in response to the Covid pandemic. The sums spent were staggering considering the short, sharp shock experienced in 2020 compared with the longer burn of 2008:

• Federal Reserve: $4.5 trillion

• Bank of England: £450 billion

• ECB: €1.85 trillion

Disruption to supply chains also contributed to the recent spike in inflation.

The closure of factories during lockdown coincided with rising demand. People were stuck at home with extra money in their pockets thanks to government support programmes. The combination of depressed supply and additional disposable income pushed up prices.

Just as the world started to emerge from the pandemic, Russia invaded Ukraine, causing oil prices to soar and pushing up the cost of shipping. Food prices also rose because Ukraine is a major producer of grains.

Central banks vs. Inflation

Central banks work hard to combat inflation because it has two negative impacts on a country’s economy.

Firstly, inflation reduces purchasing power, the amount of goods or services a consumer can purchase for a particular amount of money at a given time. When prices rise, purchasing power falls.

Secondly, currencies in countries experiencing elevated inflation depreciate against other currencies. An extreme example of this effect is when an economy faces hyperinflation, like Venezuela in 2021. At one point towards the end of the year- incidentally, just before the country launched a new currency- prices rose by an estimated 5,500%, and US$1 bought four million bolivar.

However, a certain amount of inflation is good for an economy. Most central banks target a rate of around two to three percent, primarily to ward off deflation. When prices fall, consumers postpone making purchases in anticipation of further drops. As demand declines, unemployment increases and depresses demand even more. Ultimately, deflation is a greater threat to growth than moderate inflation.

Bitcoin as a Potential Hedge Against Inflation

During bouts of inflation, investors tend to shift their money into ‘stores of value’ like gold because they retain their purchasing power.



Despite its volatility, bitcoin is considered ‘digital gold’ in some circles because it meets several of the criteria required to be classified as a store of value:

• Scarcity- Satoshi Nakamoto, the pseudonymous founder of bitcoin, set the maximum circulation at 21 million.

• Durability- While bitcoin has only existed since 2009, the network underpinning it has an uptime of 99.98%.

• Portability- bitcoin is stored in a digital wallet which makes it easy to transport

• Divisibility- the smallest denomination is one satoshi (the equivalent of 100 millionth of a bitcoin).

According to emails sent around the time bitcoin launched, Satoshi’s reason for limiting the circulation to 21 million was an ‘educated guess’:

‘I wanted to pick something that would make prices similar to existing currencies, but without knowing the future, that’s very hard. I ended up picking something in the middle. If Bitcoin remains a small niche, it’ll be worth less per unit than existing currencies. If you imagine it being used for some fraction of world commerce, then there’s only going to be 21 million coins for the whole world, so it would be worth much more per unit.’

But the main benefit of scarcity is it makes bitcoin anti-inflationary. The limited circulation, plus its decentralised nature (a central authority doesn’t control issuance) means bitcoin’s value should remain steady and theoretically increase over time.

Another way Satoshi designed bitcoin to be inflation-resistant was by controlling the supply of new coins, a process known as halving. Bitcoin’s Proof of Work consensus mechanism relies on miners to complete a complex mathematical calculation to validate transactions. The rewards they earn in return halve roughly every four years. The latest halving happened in May 2020, with the reward currently standing at 6.25 bitcoins, while the last one will occur in 2140 when all 21 million coins will be in circulation. After that, miners will receive a share of transaction fees.

Scarcity: Bitcoin vs Gold

According to the United States Geological Survey, 244,000 metric tonnes of gold have been discovered to date- 187,000 tonnes above ground and 57,000 tonnes below ground (still to be mined). But new deposits are frequently found. For example, an exploration survey in Uganda in September 2022 located deposits which could turn into more than 320,000 tonnes of refined gold with a market value of just under $13 trillion (at the time).

Bitcoin as a Rate-Sensitive Asset

Interest rates are the main tool used by central banks to control inflation. A rise is usually followed by a rate hike which reduces the amount of money in the global financial system.

As well as affecting the cost of borrowing, rates also impact the appeal of investments. Take the stock market. Financial equities do well when rates are high because banks can increase the amount they charge when lending money to customers. On the other hand, growth equities like tech companies tend to underperform as capital is harder to obtain. However, bonds are the most sensitive asset class to rates. If an investor holds a bond paying 3% when rates rise, they might sell it and use the proceeds to buy one that comes with a higher rate.

Gold also reacts to rate changes, but they’re uncorrelated (meaning they move in different directions), as demonstrated by the chart below.



Interest rates tend to rise during periods of economic expansion to prevent the economy from overheating. Demand for safe havens is weak in these conditions. There’s also an opportunity risk to holding gold because it doesn’t generate an income, like bonds. Conversely, central banks lower rates to stimulate activity during periods of economic slowdown, when investors typically shift money into safe havens.

Research by CoinShares shows bitcoin is becoming increasingly sensitive to macroeconomic forces that influences interest rates, like inflation and unemployment data. The correlation between bitcoin and equities rose along with rates in 2022 when both asset classes experienced bear markets. This effect is unwelcome for investors who hold bitcoin to diversify their portfolios. But the outlook suggests that as monetary policy eases in the second half of the year, the correlation will fade and support for bitcoin should return.

Conclusion

Inflation is normally triggered by an increase in the amount of money in the financial system, which is why multiple rounds of QE since the 2008 financial crisis have contributed to the rise in prices over the last year or so. Other factors have also played a part too, including disruption to supply chains caused by the pandemic and the Ukraine war.

Bitcoin is recognised as a hedge against inflation because it exhibits many of the criteria required to be considered a store of value. One of the key criteria is scarcity, as circulation is capped at 21 million.

Like traditional asset classes, bitcoin has become sensitive to interest rates, the main tool employed by central banks to control inflation. Rising rates aided the bear market in 2022, but bitcoin should benefit from easing monetary policy in the latter half of 2023.

To learn more about crypto’s role in the financial landscape, read about Bitcoin’s fundamental value.