While most citizens of developed countries may not spend much time thinking about inflation, the last years have changed our perspective. Searches for inflation surged to a five-year high in May 2021, and since stayed at a high level.
What triggers all of this? Firstly, the realization that the phrase “inflation is transitory” turned out to be a meme for those interpreting it in a humorous way and a devastating experience for those near the breadline. Secondly, people working from home had the chance to spend more time investigating how the financial system works.
Some might have realized for the first time what inflation actually means and the role of central banks in this. Once you investigate inflation; eventually, you’ll come across deflation. Both are economic concepts that describe the financial situation a currency is in.
These are valuable concepts to study for anyone interested in crypto because many crypto projects draw inspiration from traditional economic theory to design their tokenomics.
What is inflation?
If you haven’t lived under a rock in the past two years, you might have noticed that things are getting more expensive. That’s one of the practical consequences of inflation.
Inflation is simply the rate at which the purchasing power of a currency declines. If last year you could still buy one pack of pasta for $1, the same pack might now cost $1.07 when assuming a 7% inflation rate, as many industrial nations report.
Yet, at the same time, your energy bills might have even increased by 20%. Inflation isn’t measured looking at individual items but at a broad mix. This brings us to the next concept: the Consumer-Price-Index (CPI). The CPI is a basket of everyday objects and other necessities such as medical care. If the price for all the items together in the basket adjusted for their weight increases by 7%, we speak of a 7% inflation.
Why does inflation happen?
Economists agree that there are broadly two significant events that trigger inflation:
- Demand-pull: happens when suddenly there is an increase in demand for certain products and supply can’t keep up. Manufacturers will start charging more for these products, and eventually, supply and demand settle at a higher price, where not everyone who wants to purchase the product can afford it. A brilliant example of a demand-pull during the pandemic was lumber, which skyrocketed in price. Another one is used cars, which have seen price changes up to 104%.
- Cost-push: happens when the price of raw materials increases and producers pass on these price increases to their consumers. One example of an organization with the power to induce cost-push is OPEC, a group of oil-producing countries that essentially dictates the supply. If oil supply drops, it becomes more expensive, which has a ripple effect as it’s used to produce many other items.
Inflation is fuelled by employees asking for higher wages (wage inflation), which makes other products more expensive. Furthermore, inflation has a psychological component as it encourages spending and investing. Spending = higher demand = more inflation; a spiral that fuels itself.
This time, inflation isn’t a result of just increased demand or costs; it’s connected to central banks’ reaction to the pandemic and governments’ policies. In an attempt to help citizens get through the crisis, some central banks have increased the supply of money in an economy.
Even in the simplistic supply and demand model, this always means that the price will change. Now that more money is in circulation, but the value of the economy remains the same, $1 isn’t worth the same as it used to be anymore.
Fighting inflation
While moderate inflation is desirable from a central bank perspective (as long as it’s in line with economic growth), anything beyond 5% is not. They have two measures in their toolkit to fight inflation. Both aim to reduce the supply of money in the markets.
Increasing interest rates
In case you’ve been following the announcements from the Federal Reserve, the central bank of the US, you might have already heard that their chair has turned “hawkish” (used to describe their actions when they are trying to control inflation) and is planning to raise interest rates.
The interest rate in question is the policy rate; the rate at which commercial banks lend money from the central bank. When these rates increase, borrowing in the economy becomes more expensive so fewer loans are given out reducing the supply. Additionally, with higher interest rates, people are more likely to leave their money in their bank account.
Open Market Operations
Central Banks participate in the open markets by buying and selling government securities from other market participants. To control inflation, central banks can sell government securities (which are seen as the safest form of investment). When people start putting money into these securities instead of leaving it on their bank account, banks’ ability to give credit is further restricted, limiting liquidity, and eventually money supply.
Currently, it seems that leading banks are resorting to increasing interest rates, and limiting their government security purchases.
What does all of this have to do with crypto?
For years, Bitcoin enthusiasts, in particular, have been vocal about their view that Bitcoin is an inflation hedge — meaning holding it you’d outperform inflation. With the latest headline inflation figure at 7.5% in the US, they are back to recommending their followers to buy Bitcoin.
That might be easy said for them as they may have invested before Bitcoin crossed the $10,000 mark.
One of the reasons they’ll mention why Bitcoin is an inflation hedge is that its supply is limited to 21 million. Another one is, that it’s “deflationary”.
Technically, Bitcoin is still inflationary — like many other cryptocurrencies.
Inflationary Cryptocurrencies
A vast majority of cryptocurrencies are purely financial. Bitcoin is used for payments, or some would say as a store of value. Other tokens like Ethereum are used to pay for transaction fees. Often there is no greater utility attached to them.
Inflation in the context of cryptocurrencies has less to do with their price increases, but more with the underlying supply assumptions that trigger inflation also in traditional systems. Inflation, then, is an increasing supply of an asset over time.
Bitcoin
Consequently, Bitcoin, even with a capped supply, is at the time of writing an inflationary asset. Every 10 minutes, new Bitcoin enters circulation. Until block rewards run out in 2140. Only then it will become deflationary.
On the topic of it being an inflation hedge, the Bank of America believes that it’s not. Ultimately, how you perform with Bitcoin vs. inflation might be down to your timing.
PoS currencies
Proof-of-Stake networks secure the blockchain by letting anyone who holds the native token become a validator. It’s assumed that because these have something at stake, they’ll behave in the best interest of the platform.
To reward them for locking up their capital, POS blockchains offer staking rewards to validators. The higher the rewards, the higher the inflation rate of the network.
As a staker, earning 25% on your holdings every year is an attractive proposition. However, one shouldn’t dismiss the challenges that this increase in supply means for the network over time.
Even in the most optimistic scenario that everyone on earth, one day, is using that cryptocurrency, how will the price of the token keep up with an increase of 25% in supply every year — when there are no new users to be gained?
Some Proof-of-Stake currencies implement other mechanisms to reduce supply to control inflation and have a limited supply. But what happens when all supply has been distributed? In that case, the only way for validators to earn will be from transaction fees.
Until now, there is no PoS blockchain that has reached that point, but once any does it will be an interesting case study.
At Minima, we believe that an asset underpinning the future Web3 can’t be inflationary if it is supposed to facilitate value transfer and storage.
That’s why we have opted for a deflationary token model, one where no new tokens ever enter circulation after all tokens have been vested.
