What does inflation have to do with Bitcoin anyway?

On Thursday, the US Federal Reserve – or “Fed” as everyone likes to call it – made an historic policy shift, which could have far-reaching consequences for crypto… and Bitcoin in particular.

The change concerns inflation, and how fast it will erode the value of the US dollar in the coming months and years.

Essentially, the US has decided that higher inflation – and thus having to spend more money on everything in your life – isn’t so bad after all.

From CNBC:

In a move that Chairman Jerome Powell called a “robust updating” of Fed policy, the central bank formally agreed to a policy of “average inflation targeting.” That means it will allow inflation to run “moderately” above the Fed’s 2% goal “for some time” following periods when it has run below that objective.

As you probably know there are innumerable arguments for why inflation is good or bad.

But generally a small amount of inflation is seen as a positive for society.

It means the economy is working. Demand for products is high and so prices are increasing. The stockmarket is rising in value, banks are lending out money and wages are going up.

That’s the theory, at least. But in practice is doesn’t necessarily work that way.

As the Pew Research Center pointed out in 2018:

“Today’s real average wage (that is, the wage after accounting for inflation) has about the same purchasing power it did 40 years ago. And what wage gains there have been have mostly flowed to the highest-paid tier of workers.”

So inflation has basically kept people’s day to day “purchasing power” unchanged since the 70s. What’s so bad about that?

Because at the same time, asset prices have vastly increased.

For example, in the 40 years between 1978 and 2018 every $1 invested in the S&P 500 would now be worth $20.92.

And that’s after inflation, as you can see in the calculation below:

Source

So while people who can’t afford to invest in the stockmarket have seen zero growth in the amount of money they have – and what they can do with it…

Those who can afford to invest in stocks have seen a more than 20x increase in their wealth.

And by “those”, I don’t just mean wealthy individuals, I mean financial institutions as well.

Now, many people may not know or care that they could have seen a 20x return on their money if they’d been able to invest it and track the S&P 500 for the past 40 years.

But most people certainly do care if they can afford a family home or not.

Over that same time period the inflation-adjusted price of a family home in the US has increased by $91,850. From $172,598 in 1978 to $264,448 at the end of 2018.

(Source: Don’t Quit Your Day Job, using data from The National Association of Realtors, The Federal Housing Finance Agency, Robert Shiller, and the U.S. Bureau of Labor Statistics.)

As Inc. reported in 2019, “In 75 Percent of America the Average Worker Can’t Afford the Median Home”.

So, despite wages keeping up with inflation, the amount of money people have to spend is much lower, because they have to save a much higher percentage of their wage for a house deposit.

Not only that, but their rent is also higher.

Between 1960 and 2014, inflation-adjusted rents have risen by 64%. (Source: Apartment List, using US census data.)

So whether people want to buy a home or not, the amount of spending money they have is massively down.

The only reason more people aren’t now struggling to live (well, not “the only reason”, but you get the point) is because the norm is now for both parents in a household to work.

Back in the 60s and 70s, the majority of households only had one working parent, as you can seen in the chart below from the Pew Research Center:

In summary: people’s wages have kept up with inflation, but their actual cost of living has massively increased… which is exactly what inflation is supposed to measure.

Confusing, isn’t it?

And as usual, this has helped the rich get richer and the poor stay poor.

The rich can afford to buy assets which increase in value much faster than inflation. Meanwhile the poor suffer from increased housing costs and no real wage growth thanks to inflation.

What if there was no inflation?

This all begs the question, what if there was no inflation?

That would be bad for business… which, in theory, would be bad for everyone.

If $1 (or £1 for those of us in the UK) is worth less today than it will be tomorrow, there is an incentive to do something with it… spend it, invest it, use it to build a business or borrow against it.

If that $1 is worth exactly the same tomorrow – or a decade into the future – as it is today, there is much less incentive to do any of those things.

And all of those things are what keeps business in business.

The real problem begins when you go into negative inflation, or deflation.

If that $1 is worth more tomorrow than it was today, there is an incentive to just hold onto it and not spend, invest, or build a business with it.

If people stop spending money… businesses stop making money… they have to lay off employees, unemployment increases, tax revenue decreases and the entire economic system collapses… taking everyone down with it.

So while inflation makes everyone poorer, deflation could bring the entire country crashing down on top of its citizens.

At least, that’s the theory.

As Investopedia points out:

“In reality, inflation can be either good or bad, depending on the reasons and level of inflation. In fact, a complete lack of inflation can be quite bad for the economy. A modest amount of inflation can actually encourage spending and investing, as inflation can slowly erode the buying power of cash—so it is relatively less expensive to buy that $1,000 appliance today than the same $1,000 in a year.”

What does all this have to do with Bitcoin?

In order to keep the economy ploughing along during hard times, the Fed – or any central bank for that matter – primarily does two things.

1. decrease interest rates.

If interest rates are lower there is less incentive for people to save and more incentive for them to borrow and spend money… to buy assets and start businesses.

However, if interest rates are already at or near zero, then the Fed can’t reduce them anymore, so it has to then…

2. print more money.

What this means in reality is that the Fed buys assets itself – usually in the form of  bonds – from its nation’s banks… with money it creates out of thin air.

This is then supposed to stimulate the banks to buy other assets with that money and also start lending it out to businesses.

Although, as Investopedia points out, banks generally decide they would prefer to hold onto that free money they’ve just been given, rather than let other people use it.

From Investopedia:

Starting in 2008, the U.S. Federal Reserve started a quantitative easing program by increasing the money supply by over $4 trillion. This had the effect of increasing the asset side of the Federal Reserve’s balance sheet, as it purchased bonds, mortgages, and other assets. The Federal Reserve’s liabilities, primarily at U.S. banks, grew by the same amount. The goal of this program was for banks to lend and invest those reserves in order to stimulate overall economic growth.2

However, what actually happened was that banks held onto much of that money as excess reserves. At its peak, U.S. banks held $2.7 trillion in excess reserves, which was an unexpected outcome of the Federal Reserve’s quantitative easing program.

But to get back to the point… both of these methods will – Bitcoin proponents argue – push up the price of Bitcoin.

If inflation increases, that means the purchasing power of each dollar is lower and so it costs more to buy the same amount of Bitcoin.

And if the supply of money is increased, it is worth less, and so you need to use more if it to buy the same amount of Bitcoin.

Of course, you could switch out “Bitcoin” for many different assets here… stocks… gold… houses.

Bitcoin is seen as insurance against an economic collapse

If you’re still with me here, you might be thinking that an inflation-induced 2% or 3% increase in the price of Bitcoin is absolutely negligible.

Afterall, Bitcoin’s price regularly moves 10% or more in a single day.

And that’s true. But the actual effect doesn’t matter, it’s people’s perception of it that does.

If people start to believe Bitcoin is a hedge against inflation – that it will rise in price faster than inflation – then they will want to put some of their savings into it rather than leave them in cash.

And their demand will push Bitcoin’s price up ever so slightly through the laws of supply and demand.

All else being equal, if an asset’s supply remains the same and demand for it increases, then its price will also increase.

The more people that see Bitcoin as a hedge against inflation, the more its price will increase… and as its price increases it will draw more demand… increasing its price even further in a feedback loop.

And as it goes up more and more, people start putting more and more money into it, because not only is it now a hedge against inflation, it’s now a good way to grow your money.

And in this way, its price can increase dramatically.

All it takes if for someone to believe an asset is worth a certain amount – and be willing to pay that amount for it – for it to actually be worth that amount.

And the same could be said of the stockmarket. Yes, some stocks pay out dividends, but many of the most valuable don’t – Amazon and Tesla being prime examples.

It’s actually ridiculous when you really think about it.

But to get back to the topic at hand… there are two main reasons people argue Bitcoin can be a better hedge against inflation than stocks.

1. Bitcoin is decentralised.

Stockmarkets are essentially a representation of how well a country’s businesses are performing.

If that country’s economy starts to suffer, people will lose faith in its businesses, pull their money out of the stockmarket and stock prices will fall.

Because bitcoin is decentralised, it isn’t tied to the fortunes of any one country. It is independent and global.

Which leads us onto the next point…

2. Bitcoin is completely separate from the financial system.

One of the big ideas behind Bitcoin is that it isn’t tied to the financial system.

Central banks’ monetary policies can’t affect Bitcoin because it operates in its own financial system.

This is mainly because there will only ever be 21 million Bitcoin in existence. That’s written into its code and no Central Bank anywhere in the world can change that.

So, no matter what happens to any given country’s inflation or economy, Bitcoin will – in theory – be unaffected.

This is arguably one of its main purposes.

After all, it was born out of the 2008 financial crisis. And its first ever transaction had the following headline written into its code: “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.”

Whether that was its creator, Satoshi Nakamoto’s intention or not, it is one of the main reasons many people hold it today. As an insurance against our current financial system.

And with the Fed now changing its tune on inflation, and continuing to print record amounts of money (in what’s been termed “QE infinity”) Bitcoin is looking to many like the best insurance policy money can buy.

Although as we saw earlier this year, during crypto’s coronapocalypse, Bitcoin isn’t really as uncorrelated with other asset prices as many people like to believe it is.

But it is able to bounce back from major market collapses a lot sooner than mainstream financial assets, as we’ve seen time and time again.

It’s a lot to think about, isn’t it?

Okay, that’s all for this week.

If you thought this issue was worth a pot of tea, you can buy me one here.

Thanks for reading.

Harry

PS This was a pretty heavy one, so I thought I’d put a picture of an inflatable pink flamingo in the sun at the end to lighten the mood.