Token Takeaways ✍️
✨ Inflation is the increase in the price of goods and services in an economy. The inflation rate is a strong indicator of an economy’s health.
✨ Inflation rates and interest rates are closely linked. When the price of goods and services rises, interest rates tend to follow, which can impact risk assets.
✨ Bitcoin is sometimes described as a hedge against inflation owing to its limited supply. However, that notion is up for debate.
Inflation has become a hot topic over the past year. Many Western countries have faced soaring prices for goods and services, prompting central banks to respond with interest rate hikes. Several factors have contributed to the crisis, including government spending and the Russia-Ukraine war. While central banks like the Federal Reserve have taken action, soaring prices have had a major impact around the world. This feature explains everything you need to know about the topic, and how it can affect the token economy.
Please note: Investing in cryptoassets is risky. Due to the volatile nature of the cryptocurrency market, investors run the risk of losing their funds when they make an investment. Returns from cryptoasset investing are not guaranteed, therefore users should always be aware of the risks.
What is inflation? 📈
Inflation refers to the rate of increase in the price of goods and services. When it increases, money has less purchasing power. This means a unit of money can buy fewer goods and services and loses value over time.
Let’s imagine a farmer sells boxes of six eggs for £1 in 2022. The inflation rate is 10%, so the farmer sells the same boxes for £1.10 in 2023. This means £1 is worth less—it cannot buy six eggs like it could a year earlier.
While rapid price rises are problematic, economists and central banks view modest inflation as a sign of a healthy economy. The Federal Reserve, the Bank of England, and other central banks generally target a rate of 2% in their monetary policies.
Token tips: Monetary policy refers to how central banks control interest rates and the money supply, while fiscal policy refers to their control of government spending. Monetary and fiscal policy are the two key levers that impact an economy 💡
While central banks have mostly kept inflation under control over the past two decades, the prices for goods such as food and energy have soared globally over the past two years. Several factors have contributed to the rising prices. Governments increased fiscal spending to deal with the Coronavirus pandemic in 2020, while Russia’s invasion of Ukraine led to increases in the cost of goods like gas and wheat in 2022. As a result, prices have risen over 10% year-on-year in countries such as the US and UK. Soaring inflation has contributed to the UK’s “cost of living crisis,” where expenses like food and heating have risen across the board.
When inflation gets too high, it erodes people’s savings as the value of fiat money decreases. In the worst cases, it can lead to hyperinflation, when prices rapidly rise. Countries like Venezuela and Argentina have battled hyperinflation in recent years.
How central banks curb inflation 🏦
Central banks use interest rates to curb inflation. By pushing and pulling on interest rates, banks aim to keep soaring prices under control. They tend to increase interest rates when inflation rises, and lower interest rates when it falls.
This is because the effective cost of borrowing and spending money increases when interest rates are high. People spend less, so the economy slows and prices must decline. And when inflation declines, people earn less on the money they save, so spending increases.
Inflation and interest rates have a close relationship, and they play a major role in a country’s economy.
As the price of goods have risen over the past couple of years, central banks have responded by hiking interest rates. The world’s most powerful central bank, the US Federal Reserve, has increased rates on several occasions since early 2021. The Fed’s current funds rate is 4.75% to 5% as it has stayed committed to decreasing inflation.
The Fed closely monitors the inflation rate and unemployment rate when deciding interest rates. When the Fed hikes interest rates, it wants to reduce inflation, but unemployment rates can increase as the economy slows down. The Fed’s goal is to find the right balance between low price rises and high employment.
While US inflation has declined in recent months, the unemployment rate has not yet peaked, suggesting that the central bank is not yet ready to stop hiking rates.
Bitcoin as “digital gold” 💵
When interest rates increase, people tend to save money to earn a yield. This means “risk” assets such as cryptocurrencies can decline in value as people flee to cash. In 2022, crypto and tech stocks were particularly hard hit as the Fed hiked interest rates.
Token tips: “Risk” assets are assets that carry a degree of risk due to factors such as price volatility 💡
While risk assets suffer when interest rates are high, some assets such as gold and real estate have traditionally been viewed as long-term hedges against inflation.
In recent years, some token enthusiasts have touted Bitcoin as an inflation hedge. Bitcoin is known as “digital gold” as it has a fixed supply of 21 million BTC. This is a stark contrast to fiat currencies like the dollar and pound, which have an infinite supply as central banks can always print more.
Token tips: Investors make “hedge” trades to protect themselves against price volatility or other types of risk. “Inflation hedge” assets are supposed to help investors beat the rate of inflation and preserve the purchasing power of their holdings 💡
However, while the “digital gold” narrative is popular, Bitcoin has not yet proven itself as an inflation hedge. As the events of 2022 showed, Bitcoin and other crypto assets trade in close correlation with the stock market. This means that they are affected by high inflation and interest rates.
Learn more 💫
Inflation is one of the core concepts of economics. As inflation and interest rates have a major impact on the global economy, it’s a good idea to learn how they work now. Understanding the impact rising prices have on assets will also help you understand Bitcoin, positioning you for success in the token space.
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