Is bitcoin an inflation hedge? Yes, no, semantics.
The definition of inflation is often skewed. We dive into the nuances around this narrative.
Dear readers,
If you found this publication via Layered Money, as many of you did, you’ll perhaps remember the intentional decision to leave the word “inflation” entirely out of the book. Why? Because inflation can be a dirty word.
Inflation, in its original financial definition, means an expansion of the money supply. Historically, this correlated with an increase in price levels, and therefore inflation also became synonymous with rising prices. So is bitcoin an inflation hedge? Of course it is...not? The time has come to dissect one of the major narratives surrounding the value of bitcoin relative to the word inflation.
The bottom line is that answering this question is a matter of semantics. Let’s start with the ‘price level’ version of inflation—a hedge implies that bitcoin offsets the losses of price inflation. Well, bitcoin’s price has cratered during the latest multi-decade highs in CPI. And price inflation is a lagging indicator behind one of its root causes: money supply inflation.
In the current cycle, bitcoin actually appreciated during money supply expansion, but by the time price inflation reared its head and central banks responded by starting to withdraw liquidity from the system (even the indication of such tightening), bitcoin plunged in value along with other risk assets, down 55% year-to-date at the same time that headline CPI readings rose to above 9%.
Bitcoin’s absolute scarcity offers a debasement hedge against the US dollar and other central bank-issued currencies, not necessarily a hedge against near-term price inflation. After all, we cannot simply ignore messages from markets that extend over several months—bitcoin has not helped protect the average American against pandemic-induced, monetarily fueled, fiscally stimulated price inflation of the past year, but it still has appreciated several hundred percent since the pandemic began and QE infinity was unleashed. Trying to pick through the semantics of price inflation and monetary inflation only results in bickering, when the big picture is clear: bitcoin hedges our exposure to bureaucratic mismanagement. And that is something we all need, because between the blindfolded dart throwing at the Federal Reserve and the head-in-the-sand zealots on both sides of the aisle in Washington DC, we must seek protection. Does it really matter how we define inflation, when all we’re trying to do is build little citadels to protect our families and the fruits of our labor? Allow us to explain why ‘inflation hedge’ is a misnomer and explain why bitcoin is valuable no matter how you choose your definitions.
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Muddled language
Inflation is mostly used in the financial media to describe price inflation, measured by the rate of change in the Consumer Price Index basket of goods and services. Bitcoin performs poorly in times of elevated CPI inflation, while it appreciates rapidly during periods of another kind of inflation: money supply inflation.
Money supply inflation [i.e. credit expansion] leads price inflation by several months. As the broad amount of money and credit expands and individuals borrow cheaply and allocate into different assets throughout the system, bitcoin appreciates as some of this liquidity is drawn into its mighty orange orbit. As money supply inflation accelerates, bitcoin performs very well—an effective money supply inflation hedge. The opposite happens when price inflation, which lags credit expansion and fiscal stimulus, starts to pick up. Financial conditions tighten, credit contracts, liquidity declines, and bitcoin suffers along with risk assets (remember that bitcoin and equities are currently 85% correlated).
So rather than tracking a lagging CPI inflation index, you should be tracking rates, which help forecast changes in both monetary policy and price inflation expectations, the latter being the result of economic expansion and contraction.
Bitcoin doesn’t ‘hedge’ against a lagging index of broad prices increasing, it hedges against the debasement of central bank-issued currencies.
This dual meaning of the word ‘inflation’ allows intellectually dishonest people to plot bitcoin against CPI inflation and dutifully say that bitcoin’s purported scarcity is useless. Therefore, in order to be tautologically correct when we discuss the importance of bitcoin’s absolute scarcity, bitcoin is better described as a debasement hedge.
How does bitcoin perform against the expansion and contraction of broad money and credit? Exceptionally well. Here you can see bitcoin tracking with global money stock, indicating that purchasing bitcoin and holding it allows your wealth to expand and contract in tandem with the debasement of central bank-issued currencies. We will continue to monitor this relationship, especially as the Fed’s balance sheet declines over the next many months during QT2.
Debasement, both as a word and as a concept, isn’t as widely understood as price inflation, and therefore the broad understanding of bitcoin’s underlying value as a debasement hedge will continue to be under-appreciated by the market, in our opinion.
Bitcoin tracks the liquidity tide
Bitcoin tracks liquidity, which is currently being drawn from the system to fight price inflation, but the tightening of financial conditions can’t continue forever. In fact, we believe they are finally starting to shift back, ever so slightly, into easing mode:
The tide is shifting around the world as well—Europe’s periphery is flirting with another sovereign debt crisis, and emerging markets around the world are feeling the pressure of a strong dollar—liquidity will soon reenter the system from alternative sources than the Federal Reserve. We are also closely watching for a possible liquidity flood from China.
Hedge? No, debasement insurance
With bitcoin, you’re not explicitly hedging the risk of price inflation. Instead, you’re purchasing an insurance-esque policy against the current monetary order. While we observe a Federal Reserve in tightening mode, and more accurately, save-its-reputation mode, it’s almost easy to imagine why bitcoin has suffered a deep bear market. But the Fed cannot keep financial conditions this tight for much longer, especially as future price inflation expectations are coming down. Ironically, it is the decline in forward price inflation expectations that will provide a bottom for risk assets, including bitcoin. That decline in expectations is the direct result of the market believing that the Fed’s tightening has been effective, and that it will draw back on its tightening in due course.
Until next time,
Nik & Joe
This post was sponsored by Voltage, provider of enterprise-grade Bitcoin infrastructure.
