How Does Bitcoin Work As A Hedge Against Inflation?

Inflation is on the rise once again. Here in India, the annual inflation rate has been on the increase for five straight months, and it’s a similar story in many parts of the world. As such, people are looking for ways to protect their savings from the devaluing effect of inflation, and cryptocurrencies like Bitcoin offer a seemingly perfect solution.

In the short time that it has been around, Bitcoin has worked well as a hedge against inflation. It has delivered burgeoning returns and is even being referred to as digital gold. This harkens back to when gold was one of the only commodities people used to protect themselves from the reducing purchasing power of fiat currency.

But why is Bitcoin being touted as a hedge against inflation, and can it really offset the diminishing value of fiat currencies? Let’s find out.

Understanding inflation

In a nutshell, inflation refers to the rising prices of goods and services. When prices rise, the purchasing power of the masses diminishes. As a result, more fiat currency is required to purchase goods or services that you would have bought for a lesser amount in the past. For example, a chocolate bar sold for 20 rupees two years ago is selling for 30 rupees today. This is due to inflation.

There can be various macro and micro reasons for inflation in an economy. However, most experts agree that sustained inflation occurs when there is an increased supply of fiat currency in circulation that does not match the country’s economic growth.

Typically, a country’s central bank is responsible for controlling inflation. It keeps a check on the supply of fiat currency in circulation and maintains credit limits for the well-being of the national economy.

How does a hedge against inflation work?

Ideally, a hedge against inflation is supposed to appreciate in value, even as the purchasing power of fiat currency diminishes. Historically, gold and real estate were standard assets for protection against inflation. These assets generally maintained and even increased in value during periods of inflation. By investing in these assets, you effectively protect your savings from the devaluing effects of inflation.

However, there has been a steady decline in investor interest towards gold. While it is still a decent investment for the long-term, it does not offer the same returns as it used to. Moreover, it is very difficult to transport and store.

Real estate has also suffered, especially after the 2008 market crash. It also has a very high entry cost, limiting investment to a select few. With traditional options not offering the same protection as they did before, people were forced to look for other assets that could serve as a hedge against inflation. Enter Bitcoin!

How does bitcoin work as a hedge against inflation?

The primary factor that makes bitcoin a hedge against inflation is its limited supply of coins. When Satoshi Nakamoto created the world’s biggest cryptocurrency, he embedded a hard-cap into Bitcoin’s source code that limited circulation to 21 million bitcoins.

Since then, around 19 million coins have already been generated, with only 2 million to go. No one can change the source code of bitcoin to increase the supply. Doing so would create a new blockchain altogether.

Therefore, with no excess supply, the coins that already exist will eventually become scarce, increasing the demand and, in turn, increasing the price of the asset.

Also, unlike gold, Bitcoin is extremely portable. It can be transferred from one corner of the world to another in a matter of seconds. It is also accessible to anyone who owns a smartphone and has access to the internet. This basically opens it up to the ‘unbanked’ masses.

Bitcoin has also had a tremendous price action since it was launched. Back in 2009, when it first came to being, it was valued at less than 1 cent per unit. Cut to the present day when a single bitcoin is worth more than $45,000. Not to mention Bitcoin’s all-time high of $67,567 in 2021.

But is Bitcoin a good hedge against inflation?

Theoretically, it should be a great hedge against inflation. It has a limited supply, making it a scarce asset. It is fungible, meaning that one bitcoin can be exchanged for another without any loss in value. It is also easily accessible, enjoys widespread acceptance and has proven appreciation as well.

However, varying factors have caused extreme volatility in its price. Bitcoin rose to popularity in late 2017 but then crashed in late 2018. Similarly, it hit an all-time high in 2021 and plummeted the very next year.

Bitcoin ‘whales’ (large bitcoin holders) have also been able to manipulate the asset’s price by buying or selling the asset in bulk. This points to speculative forces driving the price of Bitcoin. They could alter the price of the asset regardless of whether there is an inflationary period or not.

Another problem with bitcoin is the number of regulations it currently faces from lawmakers across the world. This means that the price of the asset is often at the mercy of institutions and governments. And strict regulations against Bitcoin can hinder the adoption of the asset, resulting in deprecating prices.