Crypto.Think Weekly Update (12 June 2021): Recent data concerning inflation came out in the United States that confirmed it is rising at a rate not seen in over 13 years - since the 2008 global financial crisis. While the Federal Reserve (FED) of the US is saying that this inflation is "transitory" and of no cause for long term concern, it is important to understand just what inflation means and how you can protect yourself against it.
What is Inflation?
Inflation can be defined as the general rising of prices within an economy over a period of time. As prices rise, each unit of currency within that economy loses purchasing power and grows weaker over time. This loss of purchasing power leads to a reduced ability to buy goods, including food, clothing, fuel, and so on.
Inflation is driven by numerous factors, one of which is the velocity of money within the economy. The velocity of money is defined as the speed in which money is exchanging hands. During the Covid-19 shut downs, the velocity of money slowed considerably. Since the reopening of global economies, that velocity has regained steam.
The psychological aspect of inflation can artificially create inflation through fear of inflation itself. For instance, if the general populous is expecting prices to continue to rise, there will be an increased push to purchase goods and services now. That push to buy more goods in the short term increases the velocity of money in the economy and actually drives up the prices, creating the inflation that everyone was fearing in the first place. This can turn into a vicious cycle when inflation rises exponentially, resulting in hyperinflation.
Example of hyperinflation in Zimbabwe
The idea of transitory inflation generally just means that the inflation is expected to be short term or temporary with the expectation that prices will return to their previous lower levels. The Federal Reserve is repeating the idea that inflation is transitory due to the recent reopening of the economy in which people are all returning to the world, competing for goods and services which in turn is driving up prices. The FED is expecting that this "temporary" spike in prices will return to normal as the economy returns to its usual functioning form.
With this belief by the FED, they have stated that since this recent inflation is only temporary, the FED will not be slowing down or halting their current monetary policies of quantitative easing and asset purchases. These monetary policies issued be the FED include keeping interest rates near zero and creating more liquidity in the markets.
Current Inflation Data & Outlook
As of recent inflation data that was just released via US institutions, inflation for May was calculated at nearly 5%, a steep increase from rates back in spring of 2020 during the pandemic. The following two charts give an overview of inflation in past years. The first chart on tip is calculating the change in inflation from 2010 to present day. The second chart is calculating inflation in the consumer price index (CPI) year over year:
While this visible increase in inflation has been said to be only transitory or temporary from the Federal Reserve, numerous institutions, and so on, it is also important to note other macroeconomic factors of interest that help to preserve a more complete picture of the economic outlook of the US.
Since the onset of the pandemic and the Covid-19 stock market crash back in March 2020, the Federal Reserve has been pumping new money into the economy in their quantitative easing policy, as described above. The following chart demonstrates the M3 Money Supply - a broad money supply calculation that includes liquid money such as that in checking accounts, plus savings accounts, CDs, Money Market Mutual Funds, large-denomination deposits, balances in institutional money funds, repurchase liabilities issued by depository institutions, and so on.
Visible above, the first grey vertical bar visible is the 2008 global financial crisis and major recession that subsequently took place. During this time, the Federal Reserve used quantitative easing to support asset classes and jump start the economy into recovery which can be seen by the increased rise in the M3 during that time. Since then, the FED has kept rates low and continued a similar monetary policy to help the economy continue to grow.
Considering the recession visible above, now look at the drastic increase in the M3 since the onset of 2020. This is an unprecedented increase that has never been seen in modern economics within the United States. Additionally, the chart below is an overview of the Federal Reserve's balance sheet. The Federal Reserve is now holding $8 trillion USD in assets, the highest total on the balance sheet ever recorded. The massive increase in the FED's balance sheet is seen at the onset of the pandemic in 2020, comparable to the large increased visible in the M3 chart above.
This final chart overlays the Federal Reserve balance sheet seen above with the S&P 500 stock index. During the crash back in 2020, the Federal Reserve put a floor in for the entire index by a massive increase in quantitative easing that has artificially inflated stock market prices to the levels that they currently reside at. Without that unprecedented intervention from the FED, the stock market would have had an even more violent correction than it did.
In summary, although the Federal Reserve and major institutions are reporting that inflation is expected to be transitory due to the general population re-entering the economy and driving up demand, it cannot go unstated that the Federal Reserve has significantly increased the money supply during that same time period while also keeping interest rates at near zero, channeling demand for investors and institutions to continue taking on debt for leverage and asset purchases.
An important note to keep in mind about inflation is that it takes time for it to transition from asset classes that are considered "good" inflation, such as investments like the stock market as seen in the FED-fueled rally above, to what is considered "bad" inflation in core consumer goods that affects the average person's ability to purchase necessities. The money is now in the economy, it simply is just taking time to find its way into different sectors. This is in part why inflation, up until the past two months, has not really shown any reason for concern.
Additional factors to keep in mind with the increasing money supply and returning demand in the economy are various food shortages due to external environmental factors, kinks in major global supply chains due to disruptions from Covid-19 shut downs, and unforeseen shipping delays due to events such as the 2021 Suez Canal blockage.
The Case for Cryptocurrencies as Protection Against Inflation, De-valuing USD
Cryptocurrencies are currently positioned as one of the best hedges against inflation due to scarcity. The US dollar is slowly losing its purchasing power due to the rapid increase in the money supply itself. The more US dollars that are printed and sent into circulation, the less value each individual dollar has. So, the more dollars out there, the less each dollar is worth.
Cryptocurrencies help to combat this problem with scarcity. For this example and analysis, let's take a look at Bitcoin. The cryptocurrency Bitcoin has a fixed supply of only 21 million coins ever. This supply will never increase or decrease. This means that the number of Bitcoins will never change, allowing for holders of the currency to ensure that the value of their accounts cannot be reduced simply by an inflating money supply.
Once all the Bitcoins have officially been mined (there are 18,700,000 currently mined and in circulation), demand and utility for Bitcoin will continue to increase over time while the supply of Bitcoins itself remains fixed, helping to push the price up. This means that purchasing Bitcoin today, regardless of any major volatility, will show returns over the long term so long as demand continues to increase due to that fixed supply.
Fiat currencies such as the USD do not have this luxury, and due to the centralized control over the fiat money supply, it can be mismanaged and end up hurting the general populous through a reduction in purchasing power and subsequent reduction in standard of living. Bitcoin and cryptocurrencies offer protection from this while also offering a unique store of value that, in time, will have significantly more liquidity than purchases such as gold or silver as cryptocurrencies become more widely accepted.
My Thoughts & Summary
Whether inflation will continue to increase or stick around over the medium to long term is impossible to predict with 100% certainty, I believe that the current policies of the Federal Reserve, combined with the massive amounts of stimulus to soften the economic blow of Covid-19 shut downs has had an obvious affect on the purchasing power of the US dollar. The money supply has increased at a profound pace since 2020. This is a fact.
Additionally, outside of a mismanagement of the money supply are the external factors such as reduced supply chain efficiencies and rising demand within the economy which also contribute to the rising inflation that is visible in the charts under the Current Inflation Data & Outlook section above. A combination of all these factors plus an understanding of how psychology plays its own role in creating inflation is important to understand the potential future outlook of the economy, where inflation could be going, and how to ultimately prepare for it.
Should you rush out to the store right now and buy a ton of goods due to potential inflation? No. We do not want to contribute more to the problem that is already transpiring. That said, it is fundamentally important that you prepare and protect yourself in the event that inflation is not transitory and problem persists - but in a way that does not incite panic buying. Instead of rushing out and overbuying on goods like we saw during the initial onset of the pandemic, simply buy a few more items each grocery store trip to slowly build a food supply. Research hedges against inflation such as cryptocurrencies like Bitcoin as well as precious medals and other asset classes that historical perform well in periods of inflation. Reduce unnecessary purchases where you can and move money out of normal fiat such as savings accounts.
Time will ultimately tell how these factors all play out. It is entirely possible that inflation being seen right is indeed transitory, but it is important that you take the steps to at least prepare for the event in which it isn't.
