Inflation

Inflation is the rise in prices in an economy over some period of time for a specific good or a typical basket of goods and services.

In the US, we use the Consumer Price Index to measure the prices of the basket of goods and services consumed by the average American household.

Investors should be concerned about inflation, as rising prices erode the purchasing power of consumer’s assets, especially assets held in cash and fiat currencies like the US dollar. For example, the median price of homes sold in the US in July 1992 was just under $100,000. By the end of 2021, less than 30 years later, the median home price had risen to over $350,000. An investor would have needed to earn a 4.2% annualized after-tax return on their cash to keep up with rising house prices, a difficult task with interest rates near zero for the last ten years.

While some of this price increase may have been due to larger houses or houses with better technology, the majority of this price increase is due to rising level of prices in the economy. That is, dollars today buy less than they bought 30 years ago. Of course, many goods, especially technology, have prices that decline over time. Compare the price and quality of a 1992 television or cellular phone to understand the power of technology to improve economic outcomes.

One of the promises of cryptocurrencies and digital assets is to serve as a store of value. A store of value is an asset where the value remains constant or even rises over time. For example, the price of gold in July 1992 was $343.60 per ounce, which rose to $1,820 per ounce by the end of 2021. Gold served as a store of value over the last 30 years, increasing in price by over 3% per year in excess of the rate of inflation.

One of the drivers of rising prices is increased money supply.

Monetarist theory predicts that an increase in money supply greater than GDP growth leads directly to inflation.

That is, if money supply increases at 7% per year when economic growth is at 4%, inflation is likely to be around 3%.

When evaluating cryptocurrencies and digital assets, inflation is a key consideration. Inflation in terms of cryptocurrencies is the speed at which new tokens are sold, mined, issued or granted through airdrops. Deflation occurs when tokens are burned or permanently removed from supply.

One of the key attractions to bitcoin is that there will never be more than 21 million bitcoin outstanding. With 19 million bitcoins outstanding today, the inflation rate is low and falling until bitcoin reaches its maximum supply in the year 2140. That is, it will take 100 years to increase the supply of bitcoin by just 10%. To the extent that a cryptocurrency has lower money supply growth than a fiat currency like the US dollar, it makes sense that the cryptocurrency could potentially serve as a store of value.

Conversely, a cryptocurrency with a large number of tokens outstanding or the potential to issue a large number of tokens may find it difficult to maintain its value. Websites like coinmarketcap.com detail the number of tokens outstanding as well as the maximum supply. XRP has 48.3 billion tokens outstanding with a maximum supply of 100 billion. Shiba Inu has 549 trillion tokens outstanding with a maximum supply of 589 trillion SHIB. By definition, the number of outstanding tokens prevents SHIB from reaching a price of $1 per token, which would mean