What is stagflation, and how could it impact the cryptocurrency markets?

Stagflation is a relatively rare phenomenon that may go alongside economic stagnation. Stagflation contrasts with inflation alongside economic growth, which occurs when prices increase alongside a higher output of the economy.

Economic stagnation occurs when the economy is not growing fast enough to meet the needs of its people. Stagflation is when the economy fails to develop and is also marked by high inflation. Stagflation can be seen as a contradiction because those circumstances usually do not coincide.

During stagflation, an economy grows so slowly that unemployment rises. Meanwhile, prices continue to increase as if companies sell everything they can produce. There is a smaller demand for goods and services, which may lead to even greater unemployment.

In an economy with high inflation rates, individuals do not know how much capital they will be able to spend in the future. Inflation makes it hard to plan and invest in the present because no one knows what their income will be after a certain amount of time. That causes even more uncertainty and slower growth. Thus, stagflation is a combination of two words: economic stagnation and inflation.

One of the most adequate examples of stagflation was during the 1970s, when several developed economies experienced slow economic growth, high unemployment and rising inflation due to global fuel shortages. Stagflation may also happen due to monetary or fiscal policy, such as when the United States decoupled its dollar from the gold standard in said period.

Stagflation can be caused by an increased cost of living that outpaces consumer demand or production levels or a reduction in the gross domestic product, which can happen when a government imposes austerity measures. There are several other causes of stagflation, including supply shocks and monetary policy errors.

A supply shock is an event that causes prices to rise without any change in aggregate demand or companies’ inventory. These shocks can be provoked because of human actions. For example, a conflict between states may increase oil prices or another essential input into the production process, leading to cost-pull inflation, which is inflation due to an upsurge in the costs as a result of rising wages and raw materials.

Supply shocks can also include increases in prices due to natural disasters, leading to higher prices. Simply put, a change in the production process thus results in a decrease in the supply of goods or services, leading to demand-pull inflation, a specific type of inflation caused by supply shortages.

Monetary policy errors refer to how central banks manage their country’s money supply. Suppose they make too much money available for lending due to low interest rates. In that case, interest rates will fall, causing inflationary pressures on consumers’ wages and prices. However, with very high interest rates, a decline in economic activity may also result in stagflation.

Cryptocurrencies have not been around for very long. Hence, there is not much data yet on whether cryptocurrency is a good investment during stagflation and if stagflation is generally good or bad for the markets.

To grasp if cryptocurrency investments work well during stagflation, one can examine how traditional markets behave during inflation or stagflation and why. Stagflation is naturally bad for traditional markets, and as cryptocurrency markets have a high correlation with general indexes, meaning that negative sentiment can trickle into cryptocurrencies which are digital assets managed with cryptographic algorithms.

In general, investors who have their money in traditional instruments may be more willing to ride out periods of economic uncertainty than those who invest in cryptocurrencies that go along with higher volatility. During stagflation, there thus may be less demand for cryptocurrencies than usual.

Stagflation may also hurt cryptocurrency markets because it makes retail investors less interested in buying digital assets. After all, high inflation directly impacts how much money people have to purchase cryptocurrency, which is considered a more risky investment.

Yet, depending on one’s cryptocurrency investing strategy, one may choose to invest in these assets over traditional financial instruments. Cryptocurrencies run on a blockchain and are not tied to any particular country’s monetary policy like fiat currencies are. When inflation rises in one country but not another, investors can still capitalize on gains realized through cryptocurrency investments, even if their home currency loses value due to inflationary pressures.

Investors will often look for a way to protect their wealth from stagflation, especially in countries like Venezuela or Argentina, where hyperinflation occurs. Hyperinflation is when there is a speedy and uncontrollable price increase of vital goods and services in an economy. Here cryptocurrency investments work well during stagflation as they provide an alternative payment means and protect against hyperinflation. Individuals may choose to flee hyperinflation by re-directing some of their reserves into Bitcoin (BTC).

As stagflation goes alongside high inflation and economic downturn, BTC can be seen as a hedge against inflation and simultaneously as a risky asset whose price could fall during an economic decline.

BTC may be seen through the same lens as gold, which traditionally functioned as a hedge against inflation. Indeed, BTC could naturally be an excellent hedge against inflation. First, BTC is a decentralized global means of payment beyond the control of central authorities. Governments have no control over it, making it almost immune to potential corruption and monetary policy.

In addition, BTC is a scarce asset, as a maximum of twenty-one million can come into circulation and deflationary since the number of Bitcoin that goes into circulation halves approximately every four years. Because of this scarcity and finiteness, it is also called digital gold or a “store of value.”

In general, the prices of risky investments fall when interest rates rise. As the cryptocurrency market developed a significant correlation with the stock markets, much will depend on if and when BTC can break its correlation. This process will likely take time, also given institutional adoption.

Stagflation could be a catalyst for BTC and cryptocurrency adoption. This could happen if it turns out that the debt economy we build on is unsustainable. When Bitcoin is seen as an alternative or hedge against a failing financial system, prices and adoption can increase in economically uncertain times. A tipping point could come when public trust in BTC exceeds trust in the current economic system.

To fight stagflation, the government can implement monetary, fiscal and other policies that increase economic growth. Cryptocurrency may also prove to be a tool in itself.

The first tool is fiscal policy. Via an expansionary fiscal policy, one can increase government spending or decrease taxes to increase aggregate demand and stimulate economic growth. The government can cut spending to help reduce demand for goods and services, which could slow down inflation.

The second tool is monetary policy, which involves manipulating interest rates to try and stimulate the economy. Central banks use a low interest rate policy to decrease the cost of borrowing money. Interest policy can also reduce the amount of money in circulation to decrease the money supply, which may help boost economic growth over time.

The third tool is to try and reduce unemployment through active labor market policies. However, here there is the risk of built-in inflation, which refers to the demand for wage increases in the labor markets to meet the rising cost of living. Yet, this often results in businesses increasing the prices of goods and services to offset increasing wage costs.

If these measures fail, other options include raising tariffs or devaluing the domestic currency to make exports more competitively priced on foreign markets. Selling bonds or other financial instruments can decrease the money supply by taking that amount out of circulation.

Cryptocurrencies may also directly help fight stagflation by allowing people worldwide to participate in global trade without needing to go to a bank or a different institution. The increased access that people have to international markets can help improve global economic conditions and lead to more sustainable growth overall.