Monetary Policy

As the Specter of Inflation Looms, Consumers Consider Cryptocurrency

Cryptocurrency ATM at a shop in Union City, N.J., May 19, 2021. (Mike Segar/Reuters)
How Fed policy is pushing some investors into cryptocurrencies

Since the introduction of fiat money into the global currency market, the U.S. dollar has been viewed as one of the safest forms of tender for international business and banking. As the world’s reserve currency, the dollar is used as the standard unit for commodities such as gold and oil. While the dollar is still used on a global scale for international transactions, domestic consumers have been shaken as fears of inflation continue to grow, particularly after two consecutive weak jobs reports. A major root cause of this distrust: volatility in the Federal Reserve’s policymaking.

Deutsche Bank has published a new report highlighting these concerns, titled “Inflation: The defining macro story of this decade.” They remark that “U.S. macro policy and, indeed, the very role of government in the economy, is undergoing its biggest shift in direction in 40 years. In turn we are concerned that it will bring about uncomfortable levels of inflation.”

For one, the bank has skirted around designating a concrete inflation policy. Vague language about “average inflation targeting” has been a source of ambiguity with consumers and investors having little to no knowledge of how the Federal Reserve plans to tackle inflation as the CPI is set to rise upwards of 3.5 percent. Because policymakers are in disagreement as to a proper balance of growth and inflation, the target value keeps increasing, furthering uncertainty and increasing the perception of the Fed as a volatile and unpredictable institution. This rising uncertainty, coupled with historical changes in inflation policy, particularly in the COVID-19 pandemic era, when the Federal Reserve has been no-holds-barred in terms of expansionary monetary policy since the onset of the pandemic, and contrary to other central banks, it shows no sign of stopping. This approach signals that the bank is tied down to policies from the pre-pandemic era, noting that overheating can be likely if the bank fails to slow down the rapidly growing economy.

The growing concern over the Fed’s inability to properly execute policy has two major implications. First, a decline in trust among consumers. A survey from Axios finds steadily decreasing consumer confidence in the U.S. central bank. In most demographic groups, including college graduates and senior citizens, less than 40 percent express confidence in the Fed, with only 34 percent stating that they have a moderate or high level of trust in the central bank.

Second, a decline in dollar confidence on the global stage. Some investors warn that the dollar could lose its status as the global reserve currency. The Fed’s decision to hold interest rates at zero, coupled with trillions in asset purchases, has coincided with a decrease in foreign holdings of U.S. debt by 2 percent, or $127 billion, in the past year alone. Moreover, the Fed has become involved in many other activities besides monetary policy, creating a “mission creep.” These actions have put the wind in the sails for a move toward cryptocurrency, ranging from Bitcoin to Ethereum, as a new medium for exchange. Simply put, consumers pay attention to central-bank policy and, at least some, will not take rising uncertainty forever.

Examining investor incentives yields a common theme in that nations and individuals alike want to be free from interest rates controlled by a volatile central bank, or unpredictable policies from an unstable U.S. federal government. Enter Bitcoin, a safe haven for investors transitioning away from fiat currency into a competitive currency market, where the ability to exchange money digitally without regulation looks increasingly attractive. While there is great volatility surrounding cryptocurrency, stemming from seemingly random price spikes and drops, this volatility can excite investors. Believe it or not, the high-risk, high-reward nature is thrilling to investors — if they are choosing to invest in increasingly risky U.S. treasuries because of Federal Reserve blunders, or high-risk cryptocurrencies, the choice is ultimately clear. Results such as these have already been noted empirically in Venezuela, where rampant inflation combined with poor governance by the country’s central bank is pushing citizens of all socioeconomic statuses to Bitcoin and other cryptocurrencies.

While there are risks, to be sure, cryptocurrencies are inherently decentralized and confer various benefits over fiat currency, which explains why investors turn to it as an alternative — the lack of ties to world economies, low online payment fees as opposed to credit cards and money-transfer services, and security due to the nearly impenetrable nature of blockchain technology all make it an extremely attractive competitor to the dollar. Certain cryptocurrencies have seen immense growth in 2021 and are trending high; besides the major players Bitcoin and Ethereum, Cosmos and Dogecoin have seen 139.17 percent and 7,709.67 percent growth in the past year respectively.

Players in these markets are not just restricted to the ultrawealthy either, with the demographics of cryptocurrency investors being centered mainly among Millennials (ages 18 to 34) who mainly focus on Bitcoin, Ethereum, and Litecoin. These investors are looking not only to the short-term profits but also to long-term trends that make cryptocurrency much more lucrative than many centralized currencies. That’s one of the long-term bets that crypto investors are making: Despite short-run growing pains, decentralization will be more stable and prices will be more informative about value in the long run.

Another reason investors might flock to crypto is its finite supply. Unlike fiat currencies that are often influenced by central banks that can expand the money supply, a fixed supply can create more discipline in the market. Admittedly, there is a lot of debate in the popular press, but fundamentally many of these debates are philosophical, coming down to whether someone believes that a central bank that effectively prints more money actually brings more value into the economy.

As concern about inflation and “mission creep” begin to mount, investors will increasingly flock to cryptocurrencies. Time will tell how much of the surge in cryptocurrency activity is genuine versus just buzz and sentiment-driven, but already it is proving to be an oasis that is free from government intervention and manipulation by centralized authorities.

Christos A. Makridis is a research professor at Arizona State University and a digital fellow at Stanford’s Digital Economy Lab. He holds doctorates in economics and management science & engineering from Stanford University. Raghav Warrier is a rising sophomore at the Barrett Honors College at Arizona State University, studying computer science, economics, and mathematics. His interests include digital economic trends and quantitative economic analysis.

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