Updated: Aug 30, 2022
As CPI has recently skyrocketed to shame the central banks and the idea of technocratic central planning, I have observed a flurry of commentary from traditional finance analysts concluding “Bitcoin has failed as an inflation hedge.”
It is striking how confused this debate is about the nature of bitcoin. It indicates a deep misunderstanding of bitcoin, the narratives around it, and more fundamentally, the meaning of inflation.
The core assumption of the “not inflation hedge” camp is that bitcoin was supposed to be a hedge against consumer price increases. And, the facts on the ground are that CPI has been on a tear in 2022 while bitcoin has dropped in price. Therefore, bitcoin has failed as an inflation hedge.
The fundamental issue lies within a misunderstanding of the term inflation – the assumption that “inflation” equals “CPI”, hence, “Inflation hedge” equals “CPI hedge”. But, as Milton Friedman (1970, p. 24.) famously wrote, “Inflation is always and everywhere a monetary phenomenon.” Should not the above financial analysts be aware of this already?
The term inflation strictly refers to the debasement of money. For added emphasis we can call this phenomenon monetary inflation. For a history of debasement take a look at Bitguide’s new course: The History of Money I.
The mainstream pundits and general public have a totally different conception of inflation – increase in consumer prices.
This nuanced distinction can cause a categorical misunderstanding in where bitcoin is headed. Let's examine what forces drive CPI and whether they are bearish or bullish for Bitcoin?
CPI can rise due to supply shortages
Like all other prices, consumer prices rise respond to two factors: supply and demand.
As the world economy is rattled by mandatory lock downs, disruption of just-in-time supply chains, war, de-globalization, and a chronic under-investment in energy, we naturally face a dire shortage of goods. And 2022 has particularly been the year of global supply disruption after COVID had already wreaked havoc in the economic machinery. These issues have contributed to a rise in consumer prices across the globe.
How do these developments impact bitcoin? CPI shocks squeeze consumers and dampens spending. Energy and commodity price shocks increase production costs and reduce margins. Ultimately, corporations get squeezed both from the demand side and supply side. The economic growth slows down and corporate profitability and credit-worthiness get a serious hit. As a result, banks become risk averse and halt lending. As we know, money supply is largely driven by bank lending and when bank credit dries up money supply contracts. The Federal Reserve too will do what (the little) it can to assist bank balance sheet contraction.
Additionally, in the face of deflationary money, the deeply indebted global economy comes under financial stress and the interest on trillions of unproductive debt cannot be paid. As a result, economic players are forced to sell any assets they have on the balance sheet to avoid bankruptcy- beginning with the most liquid ones such as bitcoin. This puts sell pressures on all asset markets and a relatively small but global market that is open 24/7 gets especially hurt.
And, when money contracts what do we expect bitcoin to do? Being a hedge against monetary inflation it should under-perform in deflationary periods. Bitcoin is functioning as advertised!
Supply shocks are bearish for Bitcoin!
For a fantastic take on this topic see this article from Swan’s Steven Lubka.
CPI can rise due to monetary inflation
But consumer prices can also rise because of excessive demand due to monetary debasement, i.e. inflation. This is a driver of bitcoin’s performance as all currencies are getting debased on a long-term basis.
As Hayek notes monetary debasement has been a norm throughout the history and this decade is no different. Soon after the recession from this deflationary episode becomes visible in the Fed's lagging metrics they will panic-pivot and resume debasement and asset price inflation.
In 2020, it was the surge in the M2 money supply that kick started the massive Bitcoin bull market. It will be the same this time.
The Bitcoin vs. Fed Balance Sheet
Bitcoin vs. the Eurodollar & Global Liquidity
Confirming the above arguments, the two Bitcoin crashes in 2021 both followed tight money indications observed in the Eurodollar futures curve. In fact, the Eurodollar curve has had a staggering correlation with Bitcoin’s price. Take, for example, the spread between the December 2025 and December 2022 Eurodollar futures contracts which is one measure of curve slope and the Eurodollar market's optimism about the monetary system. It nailed the local Bitcoin top in April 2021 – peaked a few days before Bitcoin.
Since then the curve has been continuously flattening, with a spike in October 2021 which preceded Bitcoin's spike. Once again the curve is just a few days ahead of Bitcoin. The curve ultimately inverted in December 1st 2021 when the mainstream economists and analysts were completely oblivious.
The U.S. treasury yield curve lagged several months and inverted in early 2022. Finally, the U.S. stock market peaked after several months of trouble in the bond market. You can begin to see the leading and lagging indicators of liquidity in the global monetary system. The ramifications of deflationary money are first felt in the Eurodollar futures and, shortly after, in Bitcoin.
Monetary deflation is bearish for Bitcoin (and pretty much all other assets)!
Bitcoin vs. the Eurodollar Curve
As The Bitcoin Layer notes in this article, the YoY change in global liquidity closely correlates with the changes in Bitcoin market cap. Again functioning as it is supposed to.
As the TradFi is baffled by Bitcoin's behavior, let's not forget that even after a massive crash it outperforms everything else.
Bitcoin vs. Everything Else
Friedman, Milton. 1970. Counter-Revolution in Monetary Theory. Wincott Memorial Lecture, Institute of Economic Affairs, Occasional paper 33.
A Farsi translation of this article is available here.