I began my Wall Street career in the early 1980s, and that’s the last time I recall investors being as concerned about inflation as they are today. Back then, we understood inflation had been triggered by the 1971 abandonment of the gold standard, supply shocks like the 1973 oil embargo, misguided monetary policy and perverse government policies like controls on interest rates, wages and prices. The message for investors was clear: abandon stocks and bonds for gold and hard assets like real estate, invest in countries with stronger currencies like Switzerland, Japan and Germany, and don’t trust financial institutions.
Current inflation fears are different, and many investors doubt that the old hedges are still reliable. Cryptos are now a popular refuge for inflation-phobic investors, both the “digital gold” of Bitcoin and newer crypto assets designed not just to be inflation-proof, but to capitalize on rising prices. How attractive these new instruments are depends on what kind of inflation you fear.
Supply disruptions are pushing up prices, but many believe they are transient. If that’s not true, and if pandemic effects have permanently reduced economic efficiency and the willingness to work, there will be fewer goods and services available. If governments respond with stimulus spending, subsidies and deficits that increase money supply and transfer wealth from private-sector workers to government workers, retired people and the unemployed, it could fuel inflationary spirals.
If this is your fear, then the biggest problem is slow economic growth, not inflation. Crypto might offer some protection against inflated money supply, but it doesn’t create more goods and services. Many crypto ideas are tech startups implemented as decentralized autonomous organizations rather than traditional corporations. Startups thrive in growing economies, not stagnant ones.
Crypto’s advantages over traditional finance soar in war-time and financial conflict. The best bets for this scenario are the better established coins like Bitcoin and Ethereum, plus those with strong privacy protections, such as Monero and Dash.
The main focus of most US investors is on US-centric inflation fears, namely rising government budget deficits and loose monetary policy. Consider the role of politics. America’s Democrats want large spending increases on top of already huge deficits and large debt. While the party favours tax increases in principle, proposed legislation includes more tax cuts and credits than tax increases. Moreover, some of the ways to pay for spending in the Build Back Better legislation is through price controls on prescription drugs rather than actual tax increases. Legislating low prices fuels inflation rather than fights it, especially when it counts a tax increase for budget purposes.
If Republicans gain power in mid-term US elections, things are still worrisome for inflation. While Democrats are enthusiastic spenders and half-hearted about raising taxes, Republicans are enthusiastic tax cutters and half-hearted about reducing spending. When the two parties get together on bipartisan legislation, we often get the least fiscal responsibility.
And when ‘drunken sailors’ in Congress combine with politicized central bankers who seem more interested in denying or excusing inflation than fighting it, there is the potential for a virulent, persistent inflation to emerge, immune to standard fiscal and monetary measures. This may lead to nothing less than an economy-killing general loss of confidence in the US dollar, as we saw back in the 1970s. It would also threaten financial institutions and contribute to political dysfunction.
But it’s important to keep in mind this hasn’t happened yet. The break-even inflation rate on 10-year Treasuries is 2.5% per year, suggesting the market thinks future inflation is likely to be at levels considered normal before the 2008 financial crisis. While recent inflation rates have been high, the average annual rate since 2006 has only been 2.2%. Yields on Treasury securities remain very low. Prices in some key areas, including energy, seem to have peaked and may be declining.
If US-dollar inflation is your big concern, you have the simple option of moving investments to countries and currencies with better fiscal and monetary management. Crypto can be considered one such country, and in fact this scenario was the main motivation for the creation of Bitcoin back in 2008.
Overall, anyone seriously worried about inflation should use crypto as an option that can protect against some inflation scenarios and take advantage of others. It’s certainly not a magical hedge against inflation. Nearly all crypto assets have so much non-inflation-related risk that they are appropriate only as small parts of diversified portfolios rather than either core holdings or pure hedges.
Aaron Brown is a former managing director and head of financial market research at AQR Capital Management.
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