In this article, we're going to tell the real story behind Bitcoin and inflation. We cover:
- The actual definition of inflation and how it's been affecting your life
- The true relationship between inflation and BTC (and what matters more than inflation)
- The truth about future inflation and its implications for BTC
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Once again, we turn to the ever-insightful macro expert Lyn Alden
to understand the nuts and bolts of inflation.
Turns out, there are, in fact, three types of inflation:
- Monetary inflation
- Consumer price inflation
- Asset price inflation
Monetary inflation is the expansion of the money supply. For that, we usually look at something called M2, the broad money supply. This includes the currency in circulation, the deposits at commercial banks and the general account of the Treasury at the Federal Reserve (something like the government's bank account). M2 has grown over the years. A lot:
Consumer price inflation is what is commonly understood as inflation — rising prices. Monetary inflation can lead to consumer price inflation, but it doesn't have to. In simplified terms, consumer price inflation occurs when the supply of important goods (like commodities) is scarce and/or there is a lot of sudden monetary inflation. This is called supply-side and demand-side inflation. Over the years, price levels started accelerating when the world went off the gold standard:
Asset price inflation is the increase in asset prices like real estate, stocks, gold and cryptocurrencies. Depending on various factors, asset prices can rise faster or slower than consumer prices and the money supply. For example, gold prices have risen faster than consumer prices in the last 30 years:
The most important takeaway is this:
Monetary inflation leads to consumer price inflation and asset price inflation. But consumer prices can react with a lag and can be negated by deflationary forces.
Deflationary forces can be technological progress, an increase in labor supply or an excess supply of commodities.
Why is this important?
Because following the Great Financial Crisis in 2008, there was massive monetary inflation, massive asset price inflation but not too much consumer price inflation. In other words, all the new money pushed asset prices up, but food and fuel didn't change all that much.
Because of low oil prices (excess supply of commodities) and China becoming the manufacturing hotspot of the world (increase in labor supply).
For Bitcoin, this was great. It went from zero to a high five-figure valuation at its peak. As we will see in the last section, both of these factors are now changing.
But something's funny here. Bitcoin was pitched as an inflation hedge
for years. However, inflation wasn't all that high. And now that we do experience a surge in inflation, BTC is tumbling.
- The three types of inflation are monetary inflation, consumer price inflation and asset price inflation.
- If there is a lot of labor and/or a lot of cheap commodities, consumer prices don't immediately follow monetary inflation.
- From 2008 till 2020, we had mostly asset price inflation and less consumer price inflation. This is reversing.
BTC and inflation do not have much of a correlation. If anything, the recent past has shown they are inversely correlated:
Bitcoin peaked when the Consumer Price Index (CPI) came in hotter than expected in November 2021. Ever since, inflation has printed multi-decade records, and BTC has been clinging on to its previous cycle top.
However, BTC and monetary inflation are very much correlated. Just check out this graph of the year-on-year expansion in the money supply overlayed with the price of BTC:
In ape terms, this means: when money printer goes brrrr, assets like BTC rally. Hard.
You have been looking at the wrong variables all along. Not the monthly CPI prints are important. Probably also not the Bitcoin halving
. Instead, it's the proverbial money printer at the Fed and the willingness of commercial banks to expand credit. Bitcoin is a hedge against currency debasement but not against rising prices
Think of it in crypto terms: you have a shitcoin
like USD with unlimited supply and a multisig
only a few people have access to. Its supply only ever increases and never decreases. During times of accelerating supply increases, you want to swap that coin for something more scarce. Something like...Bitcoin.
However, is BTC a better hedge against currency debasement than other assets? After all, you could also invest in real estate or stocks?
Thus far, Bitcoin has been. Below is the monetary inflation-adjusted price of BTC over the last ten years. The price of BTC and the increase in money supply are almost perfectly correlated:
However, when we look at the S&P 500, we observe a different story:
The red line tells you how much the S&P 500 rose, taking into account that there is more USD in circulation. For instance, the S&P traded around $2,800 in 2018. Today it trades around $4,100. However, because the supply of USD has increased by a lot, today's $4,100 is actually worth less than 2018's $2,800.
Roughly speaking, everyone's got more money and is buying stocks, so a nominal increase in value doesn't guarantee a real increase. But it's still better than fiat currency.
This is even clearer if we look at the average U.S. house price:
Green line means nominal price, which is increasing fast. Red line means prices adjusted for money printing, which was actually dropping hard (for a while during COVID). In other words, today's average home is worth as much as ten years ago when we take money printer goes brrr into account.
Ok, so BTC (and crypto as a whole) is the best-performing asset. Case closed?
Not so fast. If past performance was the only indicator of future performance, investing would be very simple. But we need to look at the possible future development of monetary inflation and its relationship with BTC.
- BTC has been hedging its holders against monetary inflation, not against consumer price inflation.
- BTC (and ETH) have outperformed both stocks and real estate in money supply-adjusted terms.
- The future development of the money supply and Bitcoin's reaction to it determines its long-term price development.
If you had to verbalize the current global political and economic sentiment, you would undoubtedly go for deglobalization
. Type deglobalization into Twitter
, and you get a whole host of results. Even Crypto Twitter talks deglobalization:
Long story short, deglobalization is the notion that interdependence and integration between different parts of the world will decrease instead of increase.
How does this matter for Bitcoin?
Deglobalization is driven by geopolitical developments. In 2022, geopolitical risk has skyrocketed. The Ukraine war and the Taiwan crisis are just the most obvious (and most important) conflicts, but there are many others brewing in the background.
The markets currently expect the Fed to be fairly close to "peak hawkishness:"
In this timeline, the Fed is correctly and accurately timing the peak of inflation — and will hike more slowly, eventually stopping as consumer price inflation finds a new equilibrium at a higher level.
But there are several reasons to be cautious about the inflation peak being in:
Deflationary Impulses From Excess Labor, Goods and Commodities Are Declining
As China moves higher on the value-added ladder and becomes increasingly antagonistic, the relationship between China and the West could fracture. This is likely just the beginning:
Supply chains are going to change permanently. Governments are wooing semiconductor manufacturers
to return or relocate from contentious regions in the world. Unfortunately, you can't just transfer a semiconductor plant from Taiwan to the U.S. But it probably won't be the last industry to be invited to return.
Then you have commodities and energy prices. Care to ask Europeans about electricity prices?
Both heating and electricity are shaping up to be a major disruption for the EU in the coming years.
Is Inflation Cyclical or Structural?
The elephant in the room is whether economic warfare is here to stay or if this is just a period of increased tensions. Without consulting our geopolitical eight-ball, it's fair to say that inflation will surprise to the upside if economic warfare between the West and China/Russia continues or even intensifies.
A Tight Labor Market and Wage Demands
The labor market at the moment is undoubtedly tight:
Less boomers working means less excess labor. Which means those that are in employment can and will ask for higher salaries, especially considering rising consumer prices. Rising wages are another driver of inflation, and a shortage of labor is structural, not cyclical.
All of these factors are possible reasons why higher consumer price inflation could be here to stay. So you have the supply-side pressure we just discussed and strong demand from the labor market:
Star analyst Zoltan Pozsar
lays out his thesis that this could easily lead to the Fed having to hike until 5% to rein in inflation
. His thesis is that structural shifts in the supply necessitate a recession
because demand needs to be curbed. That means: recession first, stagflation
Uff. That's a handful. But the most important question:
What does this mean for crypto?
There are two implications. First, BTC and crypto will continue to be driven by monetary inflation
. Everyone expects the ominous Fed pivot to come where the Fed starts expanding the money supply again. Arthur Hayes is max-bidding ETH
based on that thesis. But the truth is no one knows when it will come. Above are a couple of reasons why it might come later than expected.
Second, BTC and crypto adoption will be key
. We saw that BTC outperformed all other asset classes in the last decade. However, the bigger the market, the more is needed to move it. Bigger nominal increases in market caps result in smaller percentage gains as an asset matures. The more demand from big players, the stronger the price pressure. But Tesla
recently disclosed they dumped their bag. The Grayscale discount
is still up for grabs. In short, many big players are already in BTC (but less in ETH), and the way up will be a tough one.
- Deglobalization is changing the economics of everything.
- Higher inflation could be here to stay for several reasons caused by deglobalization.
- BTC will run it back when the money printer is back on and institutions ape in again.
Macro is the name of the game these days. Once you know which variables are key, you are much better equipped to make profits in the crypto markets.
So don't fear inflation. Keep learning to stay ahead of the game.
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