Can Bitcoin Hedge Against Inflation in the Long Term?

If, during your recent trip to the supermarket, you felt that your dollar didn't get you as many groceries as it used to, you're not imagining it. You're feeling the pinch of inflation.

As inflation spreads through first-world countries and millions of people now suffer from the erosion of their hard-earned savings, the question of whether Bitcoin can be used as an inflation hedge continues to be discussed.

In this article, we’ll discuss characteristics of Bitcoin that make it a prospect for hedging inflation, as well as tactics investors can use to enter the Bitcoin market for the first time.

What is Bitcoin and How Does it Differ From Traditional Currencies?

Bitcoin, the electronic peer-to-peer cash system that came into existence in 2009 after the publication of its white paper by Satoshi Nakamoto, is largely getting recognition as a possible asset to hedge against inflation amongst other more known assets like real estate, stocks, or gold. Bitcoin´s average annual returns compared to traditional assets have been very promising.

Bitcoin is a digital asset that serves as the best monetary good among the rest of the assets in the digital ecosystem. Currently, bitcoin is the most secure and decentralized monetary network in existence. Its transactional use and set conditions for a means to store value are technologically more efficient than the traditional banking legacy system that has suffered inflation on the US dollar purchasing power.

Historically, Bitcoin has experienced big surges in its price value since its 2009 inception, making up for initial volatility in the first years with large gains over the long term.

Bitcoin´s history indicates that every price surge drives new investors and no coiners into the space through a sentiment of FOMO (fear of missing out), adding liquidity and security to the Bitcoin network. The path of new Bitcoin holders is usually to gather awareness of the asset for having new ‘skin in the game’ and realizing its positive performance against inflation as years go by.

As for volatility in Bitcoin's price, it is a hard thing to overlook, but experts suggest it will remain volatile until the market progresses in agreeing on its true value as a digital asset, at least during the current early stages.

Macroeconomically, the traditional FIAT banking system based on doubtful central bank policy shows no signs of stopping inflation, as evidenced by the pandemic stimulus injections, which increased inflation. The buildup of monetary policies has involuntarily led to unprecedented global debt levels and fragility across the financial system. A potential outcome, as a result, is a path of financial repression through negative interest rates. These macro conditions have historically benefited scarce assets whose supply cannot be altered, like Bitcoin or gold in the 1970s.

Bitcoin, as an asset against inflation, appears to be a good hedge in the long term due to its enforceable limited monetary supply, though less so in the short term. As Bitcoin is considered a risky financial asset, it responds in the same way as the markets. That said, even if the technology of the asset keeps outperforming every other asset, volatility is to be expected, much like the stock market, especially as the financial market is currently deciding on its true value.

Characteristics of Bitcoin that Differentiate it From Other Inflation Suppressants

Bitcoin does not have inflation in the traditional sense. Instead, it has a fixed supply of 21 million coins, meaning its supply is inelastic or unresponsive to price. This limited supply is designed to mimic the scarcity of gold and other precious metals and is intended to give Bitcoin a stable value over time.

Technically, even Bitcoin slightly experiences inflation as more of it is mined. But because the amount of new bitcoin is automatically reduced by 50 percent every four years, Bitcoin's inflation rate will also decrease.

The 21 million limit in the supply of tokens makes it impossible to print more Bitcoin, unlike if it was a government-backed currency like the US dollar. It would require tremendous energy to try to attack or change the Bitcoin network due to its high decentralization in users' nodes, so the network is incredibly safe. Producing new bitcoins requires crypto mining, which means significant time and energy expenditures. All transactions are registered in the blockchain through inter-connected blocks that require energy from ASICS computers.

A restricted upper limit gives Bitcoin an advantage over inflation. The fact that Bitcoin´s supply is determined algorithmically allows it to follow a very different path than the monetary policy of sovereign governments and it serves as a counter-example of loose monetary policy.

How Does Bitcoin Reduce its Coin Supply Over Time?

The amount of new bitcoin generated through mining rewards is automatically reduced by 50% every four years by halving, meaning the new bitcoin emission will decrease every four years. As halvings occur, it will be harder to obtain some Bitcoin because more of it will be mined and owned by others.

So how does inflation affect Bitcoin? It has a short-term inverse relationship as inflation increases. If inflation rises, bitcoin´s price tends to go down. This is because if inflation rises, the Federal government raises interest rates, making capital allocation go to more secure assets like bonds and removed from riskier assets like cryptocurrencies. However, if inflation slows down, asset prices rise, including Bitcoin.

Bitcoin´s supply doesn´t get inflated, but its price is volatile, for now, at least. So how do we decide if we can invest in it?

Bitcoin Front Ran All Other Assets Since It Started

Compared to other assets like gold, real estate, and stocks, Bitcoin has significantly outperformed its contenders.

According to GoodFinancialCents, Bitcoin has delivered an astonishing 1,576% average annual return from 2010 to 2021. Gold had an average annual return of only 5.14%, real estate of 13.49%, and the stock market of 15.74% over the same period.

As for total returns, Bitcoin has delivered 18,912% over the same period. Gold did 61.67%, real estate did 161.91%, and the stock market did 173.14% over the same period.

In the Realm of Digital Assets, Bitcoin Is King

According to a paper by Fidelity Investments, Bitcoin is also fundamentally different from any other digital asset. No other digital asset will beat bitcoin as a monetary good because bitcoin is the most (compared to other digital assets) secure, decentralized, sound digital money, and any ‘improvement’ will have to face tradeoffs, based on the Blockchain trilemma (blockchains can only deliver two of three guarantees at one time: decentralization, security, or scalability).

If Bitcoin has outperformed and continually outperforms all the other assets, and the US dollar is projected to continue to lose value due to inflation, what other choice is there for hedging against it?

Bitcoin and the Federal Reserve

Bitcoin has had a contentious relationship with the Federal Reserve and the central banks. It seems that Bitcoin's value goes up when the Fed acts ‘irresponsibly.’

For instance, during the early days of the pandemic, the Federal Reserve poured money into the financial system to prop it up, raising the money supply from $15.5 trillion to $22 trillion, increasing it by 40 percent. It also lowered its target rates to zero.

Dumping all this cash into the market and engaging in unconstrained monetary policy gave way to higher market risk-taking. Bitcoin's rise during that time was a clear sign that something ‘irresponsible’ was happening.

Then the price of Bitcoin crashed. This largely coincided with the Federal Reserve raising interest rates, and getting more ‘responsible.’

Bitcoin as a Hedge for Inflation: Short-Term Failure but Strong in the Long-Term

In 2022, Bitcoin lost more than two-thirds of its value amidst the highest bout of inflation seen in four decades. So it hasn't been effective in hedging against inflation, at least during the last year.

Still, the past performance of Bitcoin tells us to look into it beyond just one or two years. Bitcoin, in the macroeconomic scope, is actually a hedge against negligent central bank policy, both in the short and long run.

People are starting to realize inflation will never truly go away, and no monetary policies will change it. According to the US Inflation Calculator, the annual inflation rate for the US was 6.5% for the 12 months that ended December 2022. In November 2021, it reached 7.1%, according to the U.S. Labor Department.

According to Finbold, in 2022, Bitcoin´s inflation rate was 1.7%, five times lower than that of the United States dollar (USD), making the asset a strong candidate for surfing inflationary times.

Separating Speculation and Price Action From Scarcity and Network Activity

Bitcoin, the apex of cryptocurrencies, continues to prove itself repeatedly to doubters that it is far from ‘dead’. We have seen it persevere and outlast most of the other altcoins that are now unheard of, especially during this current bear market.

Furthermore, a good sign of Bitcoin adoption is the growth in usage and activity. According to this Bitcoin Magazine article, the number of nodes in the Lightning Network, Bitcoin´s layer 2 network solution for faster transactions, has risen from around 2,000 in January 2019 to about 17,000 in December 2022.

Bitcoin Caters to the Wealthy. True or False?

Bitcoin is definitely an effective hedge against inflation, depending on the amount of time you plan on holding it as a store of value.

It is not about striking the perfect moment or buying a whole bitcoin. It's about transferring wealth to the stronger asset, the one that will depreciate the least and hold the value the longest.

Tactics for Entering the Bitcoin Market as a New Player

Getting into Bitcoin doesn't have to be done all at once. Businesses and investors can do small and periodic purchases of Bitcoin.

• Explore dollar cost averaging (DCA) – Leveraging the DCA of Bitcoin through known exchanges like Coinbase, Gemini, or Bitfinex is a safe move that will expose investors to a position in Bitcoin.
  

• Protect your Bitcoin assets – A very necessary measure is to take the purchased Bitcoin off the exchanges and keep it in a self-custodial or cold storage wallet. That way, you are the sole custody of your Bitcoin and will not have trouble with third parties that might jeopardize your funds, like with FTX.
  

• Diversify your cryptocurrency investments – Diversification doesn't hurt. You can buy a percentage of Ethereum to avoid putting your eggs in one basket. Ethereum and the entire ecosystem usually follow the performance of Bitcoin. However, it is an entirely different project with a very different roadmap than Bitcoin, so we advise you to look deeper into the project to make informed decisions.

Navigating the Path Forward

Bitcoin might be undergoing different narratives in 2023. In the US and worldwide, it is considered a speculative tool, and people are catching up on the technology that makes it outlast other cryptocurrencies.

Public distrust due to ineffective policy from economic leaders and central banks is spreading further and deterring further Bitcoin adoption.

Hyperinflationary nations such as Argentina and Venezuela suffer debasement on their local currencies due to poor monetary policy from central banks worldwide. Innovative digital products like stablecoins and Bitcoin might be the only viable solution for total monetary debasement in developing countries.

Bitcoin's performance over time continues to paint a rosy picture. Recently, Nayib Bukele, El Salvador president, proved Bitcoin skeptics wrong with a successful repayment of an 800 million bond, after making the currency legal tender in the country in 2021.

All taken into consideration, the asset is up 37% in 2023 and with a 444 trillion market cap. The FTX debacle definitely shook up the crypto world, and a positive outcome is it separated ‘crypto’ from Bitcoin, two absolutely different things.

The long-term behavior of Bitcoin as an asset remains to be proven. Still, 13 years of operating as the primary digital store of value helped to harden the case that Bitcoin will continue to exist as the bedrock of the digital asset ecosystem.