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29 November 2022

How Bitcoin is an Inflation Hedge

Learn how inflation hedges protect your purchasing power and whether or not Bitcoin fits in as one.

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How Bitcoin is an Inflation Hedge

    Index

    What is an Inflation Hedge?
    Where Bitcoin Fits In
    On Volatility
    Broadening Time Horizons
    Wrapping it Up

With inflation reaching 40-year record highs worldwide, it seems apt to discuss inflation hedges, particularly Bitcoin as an inflation hedge. During inflationary periods, people seek opportunities to protect value and purchasing power. Many assets can serve this purpose, but not all are created equal. So, what makes Bitcoin a good inflation hedge?

First, let's start with the basics.

What is an Inflation Hedge?

An inflation hedge is an investment made to protect against inflation. In other words, inflation hedges ensure your money keeps its value over time relative to an inflation-induced erosion of purchasing power.

There are many different types of inflation hedges, but some of the most popular include:

  • Gold and other precious metals: Gold has long been seen as a safe haven asset for a good reason. Gold is scarce, durable, and has proven to be a good store of value over time. In addition, some might say that gold maintains its value through the Lindy Effect, which posits that the longer an asset or technology has been around, the more likely it is to stick around.
  • Commodities: While not as scarce as gold, commodities can also serve as inflation hedges. Commodities are the basic inputs used to produce goods and services, so they often rise in price along with inflation. Typically, commodity prices increase faster than inflation during inflation periods.
  • Real estate: Real estate is another asset that has historically been a good inflation hedge. Real estate generally moves independently from stock and bond prices, making it a good diversification tool. Additionally, as inflation increases and the cost of living increases, so does rent. Therefore, owning property can hedge against rising prices and provide a source of passive income for those who choose to rent.
  • Stocks: While stocks are not typically thought of as inflation hedges, they can be helpful in protecting against inflation. Inflationary periods often lead to economic growth, which can be good for stocks. Additionally, companies can raise prices to offset inflationary pressures, leading to higher profits and share prices.

No inflationary period mimics another perfectly, as different underlying economic conditions drive each, especially in 2022, where rising rates have yet to bring down inflation below 8 percent meaningfully. And in other advanced economies and emerging markets, the inflationary environment is even more uncertain.

Choosing an inflation hedge is not a one-size-fits-all decision — it depends on your circumstances, investment goals, and theories about the broader markets.

Where Bitcoin Fits In

Bitcoin, like other inflation hedges, is a way to protect your purchasing power from inflation. Unlike other inflation hedges, however, Bitcoin is a relatively new asset, which means it doesn't have the same long track record — lower Lindy impact — as something like gold.

So why do people say Bitcoin is an inflation hedge?

  1. Bitcoin is scarce: There will only ever be 21 million Bitcoin, and over 19 million have already been mined. Of course, scarcity alone doesn't make something a good store of value, but it's one factor to consider. Other economic forces like utility and demand also come into play (it's worth noting that Bitcoin has both).
  1. Bitcoin is durable: Bitcoin can't be destroyed or tampered with — it exists entirely digitally. This makes it a more durable store of value than gold, which can be physically damaged or destroyed.
  1. Bitcoin is immutable: No one can falsify Bitcoin transactions, reverse them, or otherwise tamper with the Bitcoin blockchain. This makes it a more reliable store of value than fiat currency, which can be subject to inflation, quantitative easing, and other bank-sanctioned financial machinations.
  1. Bitcoin has one monetary policy: Bitcoin's monetary policy is set in stone, predetermined, and transparent. No one can change it — not even Satoshi Nakamoto themself. Therefore, monetary policy is predictable, and predictability can be good for a store of value.

On Volatility

Especially in the past year, as Bitcoin prices have fallen drastically since November 2021, there's been a lot of talk about Bitcoin's volatility, casting dispersion on whether it can act as a store of value.

Coupled with the United States having the highest inflation rate in decades, it's no wonder that some are skeptical about Bitcoin as an inflation hedge. It's almost as if data suggests the opposite, that Bitcoin is losing value as inflation rises. During inflation, you want hedges to increase to maintain purchasing power.

But this data doesn't tell the whole story. Why? Because almost all other inflation hedges have seen price declines during the inflationary period we're currently in. Gold has fallen from $2000/oz in February 2022 to $1700/oz today. The Dow Jones has fallen from 36,000 to around 30,000. The NASDAQ — 16,000 to 11,000. Commodities like wheat, lumbar, and steel paint a similar story.

The 2022 markets are incredibly unpredictable, with unique abnormalities that don't repeat any historical precedent. Inflation naturally drives up asset prices, but the Fed's quantitative tightening through higher rates isn't tempering inflation as predicted.

Broadening Time Horizons

If we're going to criticize Bitcoin's poor performance in the inflationary market of 2022, we must do so with all other "inflation hedges." And when we do, we see that Bitcoin is not the outlier here.

Thought about differently, over the long term, if we look at Bitcoin's 13-year history, we see that it's maintained purchasing power in the face of inflation better than any other asset. The chart below paints this perfectly.

In the long run, inflationary periods like the one we're currently in are blips on the radar. And if we take a long-term view, we see that Bitcoin is still a strong inflation hedge. You can't even see Bitcoin's price decline with the naked eye (in terms of USD).

Wrapping it Up

Inflation is unpredictable. Asset prices respond to inflation in abnormal ways, and it's challenging to find reliable hedges. We've understood this no more evident than in 2022 when inflation has risen, but most "inflation hedges" have declined in price.

When nothing hedges against inflation, it's a tell-tale sign that there is no de facto hedge against inflation. We have to expand our time horizon accordingly, and in doing so, we see that Bitcoin has been a strong inflation hedge in the long run.

Please be aware that: Cryptocurrencies are unregulated in the UK; Cryptocurrencies are not protected under Financial Ombudsman Service or Financial Services Compensation Scheme (FSCS); Profits may be subject to capital gains tax; The value of investments can go down as well as up.

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