Will reduction of US inflation from 8.3% to 2% compared to Bitcoin and Ethereum?

Inflation is one of the key global themes in 2022, with the US at 8.3%, the UK as high as 10.1%, and countries such as Turkey seeing figures as high as 79.6%. These figures are well above the target of 2% inflation from the major central banks.

Central banks such as the Federal Reserve, the European Central Bank and the Bank of England aim to keep inflation low and stable. An inflation target of 2% helps everyone plan for the future. If inflation is too high or fluctuates a lot, it is difficult for businesses to set the right prices and for people to plan their spending.

What is the impact of 2% inflation?

To understand the impact of inflation, you need to look at the compounded impact over a number of years. Suppose you have $50,000 in your savings account; at 2% annual inflation over 20 years, your spending power will have reduced to just $33,648. Your savings will effectively be reduced by almost $17,000 just by sitting in the bank.

If wages increase by exactly 2% per year, this balances out. But historically this is not the case. The average house price in the UK has drastically outpaced average income growth. Therefore, since around the turn of the millennium, it has become increasingly difficult for the ordinary worker to save to buy their own home.

Dealing with inflation

Central banks are expected to eventually gain control over inflation using tools at their disposal. There has been high inflation in the past, so it is not unreasonable to assume that similar methods will be implemented in 2022 to reduce inflation based on past successes.

Historically, to manage inflation when it has risen above 5%, the Federal Reserve has raised the federal funds rate to exceed the level of CPI inflation. The red arrows on the diagram below indicate that this has been implemented six times over the past 20 years.

For the best part of the last 20 years, CPI growth has averaged around the 2% target. In 2022, there is talk of a “new normal”. Never has there been a more significant link between the CPI and the FED funds rate with inflation so far above interest rates.

The strategy to combat inflation spikes similar to those now affecting global markets has also been to raise interest rates beyond inflation.

In the 1970s, when CPI inflation was in the double digits, Paul Volcker, FED chairman at the time, managed to get the FED funds rate above 12%. However, the actions of the current FED chairman, Jerome Powell, are worlds apart from Volcker’s. The chart below illustrates the relationship between Fed funds rates and CPI inflation since 1970. Volcker facilitated a change of over 7.5% on an annual basis, while Powell has had the opposite effect with a negative change of 7.5%.

Crypto Inflation

Bitcoin can be seen as an asset to protect you from currency depreciation, but it has its own inflation. The inflation of Bitcoin is programmed into the protocol. Currently, Bitcoin’s inflation rate is 1.75%; however, in 2024 it will decrease to 0.875%, and it will continue to decrease after each halving event.

The only slight variation in the inflation rate of Bitcoin is related to the hash power of the network relative to the network difficulty. If there is a change in the hashrate, it is automatically adjusted by increasing or decreasing the network difficulty to control inflation.

Bitcoin’s inflation model aims to gradually reduce it over time rather than maintaining inflation at a fixed rate. The tools to control inflation are programmed into the protocol, so there is no need for a central bank or other governing body to make any decisions to bring inflation under control.

Furthermore, Ethereum is going through a significant change in inflation rates this year. Before the merger, Ethereum’s inflation rate is approximate 2.6%. This was halved after the implementation of EIP-1559 in 2021.

EIP-1559 has cut the annual inflation rate of ETH from 4.2% to 2.6%.

When the merge happens in a few months and PoS is live, this will be a negative number.

Ethereum will be safe while ETH is deflationary. The best crypto money policy out there.

— eric.eth (@econoar) 7 August 2021

After the merger, issuance will be drastically reduced, potentially resulting in a negative inflation rate below 0%, with ETH issuance around 0.3%. The change is a result of the triple halving that will take place when the 13,000 ETH daily miner rewards are removed, leaving only 1.3,000 ETH from stakes.

Lucas Outumuro of Into the Block estimated that it could go as low as -4.5% when considering network fees.

$ETH will become deflationary after the merger

ETH’s net issuance is likely to vary between -0.5% to -4.5% depending on network fees

Here is a projection of what it will look like based on 2022 historical data pic.twitter.com/KdWq072Mbz

— Lucas (@LucasOutumuro) 22 July 2022

Bitcoin and Ethereum were created after the 2008 recession to respond to the problems that have plagued the traditional banking system for years. None of the protocols aims to keep inflation close to 2%. Both networks reduce inflation over time and increase the purchasing power of the underlying assets. A negative inflation rate means holding Bitcoin or Ethereum will make it worth more in real terms over a long enough time frame.

Unlike holding fiat currencies that, even at the central banks’ target inflation rate, will fall in purchasing power, Bitcoin and Ethereum are programmed to do the opposite. Fiat inflation rates are still rising globally, although they are decelerating. Nevertheless, Ethereum will undergo an upgrade in September, causing one of the biggest deflationary events in history. How this will affect speculation on the price of Ethereum will be very interesting to see.

It is important to note that economics is not as simple as “inflation bad, deflation good.” In fact, there are many consequences of deflation that can be harmful to the economy. The objective of a 2% inflation target is to ensure that the velocity of money continues at a healthy rate.

If there is 0% or negative inflation, then it is wise to refrain from using. Holding an asset with negative inflation means it will be worth more over time, so you lose future purchasing power by spending it now. This trend can cause an economy to grind to a halt when the velocity of money falls. Therefore, central banks set a low inflation target to ensure that spending continues.

But as the example at the beginning of this article illustrated, even 2% inflation drastically reduces your savings over 20 years. Ethereum and Bitcoin have lower inflation rates, while being programmed by the consensus of the world community.

There is no central bank for Bitcoin or Ethereum, and therefore no chairman to misjudge the handling of the economy. The economy is already determined and baked into the code. If the goal of 2% inflation is to ensure that people can plan their future, what better way than to have the next 100 years laid out in front of you, as is the case with Bitcoin?