Despite being dubbed as an “inflation-proof” investment along with gold, Bitcoin and other cryptocurrencies have had a pretty rough year all things considered.
This led to Bitcoin—the world’s most popular digital currency—plummeting to 71% of it’s all-time high. While the price has picked up since then, the future still looks somewhat rocky for the entire sector.
Although massive price swings are by no means unusual territory for cryptocurrencies such as Bitcoin, their performance in 2022 has left some industry analysts at least a little bit taken by surprise.
This is because ever since these digital currencies were introduced, crypto enthusiasts have claimed that they would be an effective hedge against inflation when the wider economy experiences shocks. Even as late as 2020 in the midst of the Covid-19 pandemic, many crypto enthusiasts were still making this claim—particularly as it was during this period that cryptos outperformed the stock market and rose to record highs!
The thinking behind this was that the inherent scarcity of Bitcoin would protect its value during periods of rising inflation. Unlike central banking powers who can simply print more money, Bitcoin has a fixed number of coins, which helps it to maintain a certain level of scarcity and demand.
However, this has not proved to be true in 2022 when levels of inflation peaked at upwards of 9.5% on average. In fact, Bitcoin experienced significant price instability and plummeted to lows not seen for years. This volatility had a corresponding effect on the industry and scared off many newer investors and caused other more committed crypto enthusiasts to become skeptical of its ability to act as a long-term store of value.
One explanation for why this “inflation-proof” view of Bitcoin didn’t prove true is simply because there wasn’t enough data to base the theory on. As the first cryptocurrency, Bitcoin is a little over a decade old and came of age in a decade where interest rates were kept at record lows for unprecedented periods of time. This was a relatively favorable environment to exist in and helped to encourage investment in this experimental, largely untested new class of asset.
However, the inflationary environment present today has proved significantly more challenging,but is there actually a link between rising inflation and the current prices of cryptocurrencies?
In which ways does inflation impact cryptocurrencies?
In terms of what causes inflation and how this affects cryptocurrencies, as inflation rises, central banks such as the US Federal Reserve will often raise interest rates in response. This is to decrease the supply of money and, in turn, to prevent its further devaluation.
As a result of this policy change, many asset classes such as technology stocks and cryptocurrencies will often havetheir prices fall.
This is simply because in low interest rate environments, people can borrow with relatively low cost to them in the future. As a result, investments in asset classes such as crypto become much less risky.
As interest rates increase, this easy access to liquidity disappears and demand reduces. It also tends to decrease the appetite of investors for risk overall, given that the cost of borrowing will be so much higher going forward.
Things get even more complicated if inflationary pressures, such as those we have seen in the last year, push us towards a recession. In this environment, investors will even more desperately cling to stability. As a result, we tend to see precious metals such as gold do well, as they are viewed as relatively stable and desirable.
So, it seems that inflation tends to spook investors,and when investors get spooked, they seek out certainty and security.
What does the future hold?
Although inflation rates are beginning to come down and the economy looks to be improving, it is still not clear what this means for the future of the crypto sector. Crypto is still a relatively speculative asset and it is not yet clear if institutional investors will continue to support them. It is even less clear how cryptos might perform in future inflationary periods and whether we can expect to see a similar story.
What we do know for certain, however, is that cryptocurrencies are still a very new and experimental asset class, and we have a huge amount left to learn about them!
An author of Namaste UI, published several articles focused on blogging, business, web design & development, e-commerce, finance, health, lifestyle, marketing, social media, SEO, travel.
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