Trading Crypto: How to Use Inflation to Your Benefit

Trading Crypto: How to Use Inflation to Your Benefit

When cryptocurrencies first appeared, investors were excited about one thing in particular: deregulation. As there is no central authority over crypto, it seemed that this asset class would be completely free from the problems plaguing other instruments, especially the actions of central banks.

However, this didn’t prove to be the case as time went by. In recent years it has become abundantly clear that cryptocurrencies have a relationship with inflation rates, albeit an indirect one. Still, this dependence is not necessarily a bad thing.

This article will teach you how inflation affects cryptocurrencies and how to use that to your advantage.

What Is Inflation and Why Does It Matter?

What Is Inflation and Why Does It Matter?

The simplest way to think of inflation is as the rate at which products and services increase in price. For instance, if a carton of milk was worth $1.50 last year but costs $1.80 today, inflation is likely responsible for the change in its value.

However, milk doesn’t cost more in this example because it has suddenly become more precious. Instead, our money has become less valuable, so we need to use more of it to exchange for goods and services.

In general, inflation increases when the economy is doing well. When more people have jobs, their disposable income increases, and the population as a whole starts spending more. When people can afford to pay more, i.e., create more demand for goods and services, the rule of limited supply starts pushing prices higher.

Nevertheless, central banks don’t want to see inflation rates climb too high. The ideal inflation rate is about 2%. If it starts climbing beyond that, it means the national currency is less valuable than it should be.

So, central banks have to adjust their monetary policy to drive inflation back under control. They typically do this by withdrawing fiscal stimulus from the economy or increasing interest rates. Low interest rates correspond to higher inflation and vice versa.

Why Does Inflation Affect Cryptocurrencies?

Why Does Inflation Affect Cryptocurrencies?

Central banks have no control over cryptocurrencies, so it might seem illogical that their actions would have any impact on inflation, yet somehow they do.

The reason for this lies in risk appetite, i.e., the desire of traders and investors to buy risky assets. . Thus, there is more demand for risky assets — which includes cryptocurrencies. Again, the forces of supply and demand are at hand: the more people crave risky assets, the higher they get in price.

The opposite is also true. Risk appetite wanes when the market gets spooked, or people worry about the economy. In those instances, investors prefer safe haven assets (the Japanese yen, the US dollar, gold, etc.).

How to Use Inflation to Trade Bitcoin Better

Because cryptocurrencies are a risky asset, they track inflation closely. When the economy is expanding, and inflation is going up, so does the value of Bitcoin (and other crypto tokens). If things turn sour or inflation grows so much that central banks have to hike interest to lower inflation, cryptocurrencies also go down in price.

The pandemic is an excellent illustration of this relationship. Due to the global economic crisis that it caused, many central banks had to unleash stimulus and cut interest rates to boost people’s purchasing power. This led to nearly two years of steady inflation growth and allowed Bitcoin to reach $70,000 when risk appetite ran at its highest in 2021.

However, now that fears for the global economy are winding down, central banks are planning interest rate hikes to lower inflation. These more hawkish measures sent the whole cryptocurrency sector in decline in the last months of 2021.

In other words, if you know whether inflation is going up or down, you can predict how the cryptocurrency market will move. As a result, you’ll be able to identify the most optimal points to buy or sell Bitcoin, Ethereum, and the like.