Inflation is on the rise again. Here in India, the annual inflation rate has been rising for five consecutive months, and it’s a similar story in many parts of the world. As such, people are looking for ways to protect their savings from the devaluing effect of inflation, and cryptocurrencies like Bitcoin offer a seemingly perfect solution.

In its short time, Bitcoin has worked well as an inflation hedge. It has generated booming returns and is even called digital gold. This dates back to the days when gold was one of the only commodities people used to protect themselves against the reduced purchasing power of fiat money.

But why is Bitcoin touted as an inflation hedge, and can it really offset the declining value of fiat currencies? Let’s find out.

Understanding Inflation

In a nutshell, inflation refers to the rise in prices of goods and services. When prices rise, the purchasing power of the masses declines. Therefore, it takes more fiat currency to buy goods or services that you would have purchased for a lesser amount in the past. For example, a chocolate bar sold for 20 rupees two years ago is selling for 30 rupees today. This is due to inflation.

There can be various macro and micro reasons for inflation in an economy. However, most experts agree that sustained inflation occurs when there is an increased supply of fiat money in circulation that does not match the country’s economic growth.

Generally, the central bank of a country is responsible for controlling inflation. It monitors the supply of fiat money in circulation and maintains credit limits for the welfare of the national economy.

How does an inflation hedge work?

Ideally, an inflation hedge is expected to increase in value, even if the purchasing power of fiat currency declines. Historically, gold and real estate were standard inflation protection assets. These assets have generally maintained and even increased in value during periods of inflation. By investing in these assets, you effectively protect your savings from the devaluing effects of inflation.

However, there has been a steady decline in investor interest in gold. While still a decent long-term investment, it doesn’t offer the same returns as before. In addition, it is very difficult to transport and store.

Real estate has also suffered, especially after the stock market crash of 2008. It also has a very high cost of entry, limiting investment to a select few. With traditional options not offering the same protection as before, people have been forced to look for other assets that can serve as inflation protection. Enter Bitcoin!

How does bitcoin work as an inflation hedge?

The main factor that makes bitcoin an inflation hedge is its limited supply of coins. When Satoshi Nakamoto created the world’s largest cryptocurrency, he built a hard-cap into Bitcoin’s source code that limited circulation to 21 million bitcoins.

Since then, about 19 million coins have already been generated, there are only 2 million left. No one can change the bitcoin source code to increase the supply. This would completely create a new blockchain.

Therefore, without oversupply, coins that already exist will eventually become scarce, which will increase demand and, in turn, increase the price of the asset.

Also, unlike gold, Bitcoin is extremely portable. It can be transferred from one corner of the world to another in seconds. It is also accessible to anyone with a smartphone and access to the internet. This essentially opens it up to the “unbanked” masses.

Bitcoin has also had huge price action since its launch. In 2009, when it was created, it was valued at less than 1 cent per unit. Cut to the present day where a single bitcoin is worth over $45,000. Not to mention Bitcoin’s all-time high of $67,567 in 2021.

But is Bitcoin a good hedge against inflation?

Theoretically, this should be an excellent hedge against inflation. Its supply is limited, which makes it a rare commodity. It is fungible, which means that one bitcoin can be exchanged for another without any loss in value. It is also easily accessible, enjoys wide acceptance and is also proven.

However, various factors have caused extreme volatility in its price. Bitcoin rose to popularity in late 2017 but then crashed in late 2018. Similarly, it peaked in 2021 and fell the following year.

Bitcoin “whales” (large bitcoin holders) have also been able to manipulate the price of the asset by buying or selling the asset in bulk. This highlights the speculative forces driving the price of Bitcoin. They could change the price of the asset whether or not there is a period of inflation.

Another issue with bitcoin is the amount of regulation it currently faces from lawmakers around the world. This means that the asset price is often at the mercy of institutions and governments. And strict regulations against bitcoin can hinder adoption of the asset, leading to price depreciation.