A Contemporary Analysis of the Relationship Between Cryptocurrencies and Inflati...

A Contemporary Analysis of the Relationship Between Cryptocurrencies and Inflation

It’s the 10th month of 2022, and the federal reserve has raised interest rates about five times within the year. The last increase happened in September, resulting in a 0.75 percent increase and proposals for a new economic progression to fight inflation. On the other hand, the bear market is still in full swing, and cryptocurrencies are still taking a downward thread.

Assets are around 50% below their all-time high, and daily there are issues threatening to spur this downturn, from crypto regulation issues and sanctions from the SEC to the terra network crash, hacks, and a couple of others that appear on your timeline regularly. To top it all, we could even witness more damage with the increased inflation and the constant hike in interest rates.

While there are reasons to believe that cryptocurrencies wouldn’t respond to inflationary pressure the way centralized and foreign currencies do, we’ve seen patterns of the subsequent increase in interest rates drag down the price of cryptocurrencies.

Interest Rates And Inflation

The interest rate generally refers to the cost of borrowing money, and while several factors determine its increase, inflation tops the list. In the traditional finance system, the supply and demand of credits determine the increment or decrement of interest rates. An increase in credit demand results in higher interest rates and lower demand in lower interest rates.

Concurrently, interest rates are affected by inflation, and mostly, one of the counter solutions by the federal reserve during inflation is an increment. This is mostly a measure to improve the economy by reducing demand and amplifying the currency in circulation. Additionally, investment activities slow down, which is why we see sectors like the stock market bear the brunt.

With the 0.75 increase in interest rates, data shows that S&P 500 fell to its lowest in 2022, resulting in an overall 23% decline. Considering the fact that this represents the largest of U.S stocks and even the entire equities market, it is easy to see how much interest rates affect commodities and stocks.

Now you may be wondering what exactly this has to do with cryptocurrencies. Hold that thought; let’s see how cryptocurrencies are influenced by inflation alongside other commodities.

Inflation And Cryptocurrencies

The stock and cryptocurrency markets are two completely different sectors, and cryptocurrencies do not impact stock indices and vice-versa. However, the crypto market is more likely to follow when interest rates are pumped, and other commodities are affected. We tend to see investment activities slow down, and purchases of cryptocurrencies take the queue.

In extreme cases, some investors are pushed to sell their cryptocurrencies to hold more dollars due to the reduction in currencies circulating. During inflation, stability becomes the primary factor that most investors cling to. Ultimately, cryptocurrencies are more likely to perform better when more cash is in circulation and investors feel financially confident enough to take more risks.

Inflation reduces the value of cryptocurrencies, and in times of recession, the losses increase. With the market tilting continuously towards bearish, an increase in interest rates would further lead to diminishing value for the crypto market. On the flip side, lower inflation and interest rates could contribute to a better market condition as there is a general increase in cash flow, and investors would be looking into where to put their money.

Final Note

It won’t be a surprise to see cryptocurrencies respond to the rise of inflation despite being regarded as decentralized. There are heterogeneous factors that could contribute to market conditions, and inflation is one of them. However, their decentralized characteristics still have some notable influence since they are less affected than traditional assets and currency.