How to preserve capital during inflation using cryptocurrencies?

As major economies of the world grapple with high inflation, investors could protect their savings from value erosion by investing in stablecoins.

Just when the global economy largely recovered from the crippling effects of the COVID-19 pandemic, geopolitical tensions and the resultant supply chain pressures have once again roiled financial markets across the world.

Furthermore, inflation has once again reared its ugly head, forcing central banks across major economies to raise interest rates in an attempt to curtail runaway prices of essential commodities like food and fuel.

Despite these efforts, developed economies like the United States and the United Kingdom continue to report inflation at multi-year highs, adding even more stress on household savings and negatively impacting consumer spending.

Apart from the threat of a looming recession, these inflationary pressures have a negative impact on the value of fiat money in the hands of consumers and highlight the need for financial tools or assets that can act as a hedge against inflation.

Impact of current inflation on the global economy

Along with its impact on the purchasing power of a country’s fiat currency, inflation has a detrimental effect on the true returns generated by financial instruments, especially if the inflation rate exceeds the rate of return on investment.

Take, for example, the S&P 500 index, which comprises the top 500 publicly traded companies in the USA and acts as the benchmark index for the country’s stock markets. Having generated an average annualized return of 11.82% since its inception in 1928, this index’s performance can seem quite spectacular at the outset.

However, with the Consumer Price Index (CPI) climbing to a 40-year high of 9.1% in June 2022, the returns generated from investments made in mutual funds that mimic this index will be significantly lower.

In fact, the index has provided an inflation-adjusted historic annual average return of just 8.5%, that too when the average CPI has been much lower than the currently reported numbers.

Moreover, as the Federal Open Market Committee (FOMC) voted to increase the US Federal Reserve’s interest rate to a four-year high of 2.25% in July 2022, the U.S. dollar has appreciated significantly against a basket of fiat currencies including the euro, the Great British pound and the Japanese yen.

While this has helped soften the prices of commodities like crude oil, it has a negative impact on the value of investments made by US citizens and companies at large in these economies.

For savvy investors allocating capital toward emerging markets like Brazil, India and China, among others, the devaluation of these countries’ fiat currencies against the USD has only served to diminish returns on investments made in these markets.

What does inflation mean for cryptocurrency?

As compared to fiat currencies, cryptocurrencies like Bitcoin (BTC) have generated stellar returns for early-stage crypto investors. While the USD index has appreciated around 8% since August 2019, BTC has returned ~240% in the same period as per current prices.

This is despite BTC correcting by ~60% from its peak in November 2021, further alluding to its long-term wealth creation potential. It can even be said that Bitcoin can protect people from the negative effects of inflation.

A similar trend can be seen among other popular cryptocurrencies like Ether (ETH), BNB Coin (BNB) and Ripple (XRP), hinting at cryptocurrencies being a good investment during periods of high inflation with the potential to generate inflation-beating retirement savings.

Obviously, it is important to note that cryptocurrencies display much higher volatility compared with fiat currencies and are considered to be assets rather than pure currencies. Another aspect that favors cryptocurrencies like BTC is their limited token supply.

With the original developer team setting Bitcoin’s maximum supply at 21 million BTC, it isn’t subject to the seemingly discretionary way in which fiat currencies like the USD are printed.

This implies that under no circumstance will the number of BTCs in supply exceed the set limit, thus boding well for its long-term price appreciation potential. Even for cryptocurrencies like ETH that do not have a prescribed maximum supply limit, the mechanism of minting new tokens is based on code and computational work performed.

No entity can mint ETH tokens without having created a new block on the Ethereum blockchain and the block reward mechanism depends on set factors like the complexity of calculations performed by miners.

Compare this with the arbitrary way in which the U.S. Federal Reserve or any other Central bank in the world prints money and it is evident that cryptocurrencies operate in a much more transparent and democratic way.

Are stablecoins a hedge against inflation?

Among the broader cryptocurrency market, there are a growing number of crypto tokens being launched that are being specifically created to offer a better alternative to fiat currencies.

Known as stablecoins, these cryptocurrencies are pegged to other traditional assets like the USD and gold, with their prices held stable by maintaining reserves equivalent in value to the number of tokens in supply.

While some stablecoins are also backed by algorithms or are pegged to another cryptocurrency native to the same blockchain protocol, they all aim to provide crypto investors with a medium of exchange that can be transacted freely across geographical borders.

Compared with fiat currencies or commodities such as gold, stablecoins are potentially better suited because:

Benefits of stablecoins compared to fiat currencies or commodities

This is especially important for people native to countries like Turkey, Argentina, Ethiopia, Zimbabwe, or Lebanon, where hyperinflation has deemed their fiat currencies a risky medium of exchange. Typically used to describe a monthly inflation rate exceeding 50%, hyperinflation refers to a situation when there is an expeditious and uncontrollable price increase of important goods and services in an economy.

As hyperinflation continues to erode the value of their currencies, people in such countries could switch over to stablecoins such as Tether (USDT), USD Coin (USDC) or Binance USD (BUSD) in order to protect their capital from rapid wealth erosion.

By holding their savings in the form of stablecoins, they could preserve capital during inflation using cryptocurrencies and also benefit from the appreciation in the underlying peg to even increase the value of their savings.

Since this is sacrosanct even in a high inflation and interest rate regime, hyperinflation has minimal effect on cryptocurrencies like stablecoins. Thus, for investors in economies plagued by high inflation, cryptocurrencies can act as an optimal investment, too.

Is it a good idea to put your money in crypto during inflation?

While there have been cases of cryptocurrencies failing miserably because of security concerns, fraud, or a combination of both, there are many cryptocurrencies that have stood the test of time and continue to attract hordes of investors.

Apart from BTC and ETH, altcoins such as Avalanche (AVAX) and Polygon (MATIC), among others, could be a long-term hedge against inflation. Investors could allocate some capital toward these cryptocurrencies to potentially reap profits in the long term while also using products such as staking pools to earn additional income from these investments.

Going by historic data, it can also be a profitable strategy to prudently invest in cryptocurrencies that are currently trading near important support levels and simply hold them as a hedge against inflation.

On the other hand, stablecoins, along with other cryptocurrencies, can be held in a digital or hardware wallet just like fiat currency in a traditional bank while still helping investors to protect their wealth from eroding in a hyperinflationary environment.

In other words, stablecoins are safe from inflation as compared to currencies such as the Turkish lira, especially when they are pegged against the USD. That being said, there are a few stablecoins that have been notorious for trading below their peg, and investors would do well to maintain a cautious approach when trading or investing in them.

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