What is Inflation and Can Crypto Hedge Against It?

Photo - What is Inflation and Can Crypto Hedge Against It?
Did you know that a decade ago, $100 could buy you double the amount of burgers than it can today? It's not just a recent trend – it's the enduring impact of inflation on fiat currencies.
Inflation is the continuous increase in the prices of goods and services over time, eroding the purchasing power of currency. As prices rise, the same amount of money buys fewer goods and services.

There are multiple causes of inflation: 

1. Demand-Pull Inflation. This occurs due to excess demand in the economy. When businesses slow down the production of goods and services, prices are inclined to increase.

2. Cost-Push Inflation. This happens when production costs (such as raw materials, equipment maintenance, or rent) rise. The increased costs then lead to higher prices for finished products and services. Additionally, logistical disruptions or force majeure events (including military conflicts) can also cause cost-push inflation.

3. Built-In Inflation. Also known as a wage-price spiral, it occurs when employed workers demand and receive higher wages, causing businesses to transfer these added costs onto the consumers of their products. This cycle of wage hikes leading to price increases can become self-sustaining. 

4. Excessive Issuance of Government Currency Without Proper Backing. Constant or abrupt increases in the money supply result in a slow or sudden decline in the value of money.
The Fed continually increases the money supply by printing dollars. Source: usatoday

The Fed continually increases the money supply by printing dollars. Source: usatoday

Fiat Currencies and Inflation

National currencies show varying degrees of stability and vulnerability to inflation. Some are more prone to devaluation due to inflation, while others tend to maintain their value. For example, the US dollar (USD) is generally seen as a relatively stable currency, partly because of the Federal Reserve System's policies that help manage controlled inflation. However, even the dollar has recently felt the impact of global economic challenges, leading to atypical fluctuations. More stable positions are currently held by currencies like the Swiss Franc and the British Pound.

In countries with unstable economic and political environments, currencies often suffer hyperinflation: prices skyrocket, and the local currency becomes almost worthless. Currently, currencies like the Iranian Rial, Vietnamese Dong, and Argentine Peso are approaching hyperinflation levels. Inflation is closely linked to a country's economic policy and its ability to manage the money supply. 

Zimbabwe's annual inflation hit 800%. Source: rferl.org

Strategies to Combat Inflation

Governments and central banks utilize various methods to counteract inflation:

1. Monetary Policy. Central banks, such as the Federal Reserve in the United States, employ monetary policy tools to manage the money supply. By regulating interest rates and engaging in open market operations, central banks can influence the borrowing and spending habits of individuals and companies, thereby affecting inflation.

2. Fiscal Policy. Governments can adjust tax policies to impact the overall demand in the economy. Reducing government spending or increasing taxes can help cool down an overheated economy, whereas increasing government spending can boost economic activity during recessions.

3. Wage and Price Controls. In extreme situations, governments might impose restrictions on wages and price controls. This involves setting limits on how high salaries in both the public and private sectors can go, as well as capping prices on essential consumer goods. However, this method often leads to unforeseen consequences and can hinder economic growth.

4. Pegging to a Stable Currency. Some countries tie their currencies to the US dollar to maintain a stable exchange rate and control inflation. Nevertheless, this approach has proven ineffective in countries that heavily relied on the dollar.

How Cryptocurrencies Can Help Hedge Against Inflation

Cryptocurrencies have become recognized as an alternative to fiat money and a hedge against inflation. Investors are drawn to Bitcoin for several key reasons:

1. Limited Supply. Dubbed 'digital gold', Bitcoin has a limited supply of 21 million coins, creating a scarcity unlike traditional fiat currencies that central banks can endlessly print, leading to increased money supply and potential inflation.

2. Decentralization. Bitcoin is powered by decentralized blockchain technology, diminishing the control of governments and central banks. This aspect potentially makes it resistant to political manipulations that often cause inflation.

3. Accessibility. Cryptocurrencies know no borders and are available to anyone with internet access (and sometimes even without it), offering a shield against inflation, especially in countries with volatile currencies.

4. Store of Value. Many investors consider cryptocurrencies, particularly BTC and ETH, as a store of value akin to precious metals. In times of inflation or economic instability, cryptocurrencies can serve as safe-haven assets.
Bitcoin is often referred to as

Bitcoin is often referred to as 'digital gold'. Source: the coin republic

While inflation is a common feature in the modern economy, it can bring about significant negative effects. As governments and central banks implement traditional methods to control inflation, cryptocurrencies emerge as a decentralized alternative. With their limited supply, they offer a way to protect personal capital, serving a similar purpose to gold in safeguarding value.