Inflation fears arise in every crisis. The argument is the same now as it was in 2008: Expanding the money supply will lead to higher prices. Is this all fear-mongering or a real risk?

What has happened so far: Due to the outbreak of the coronavirus, companies are losing sales. Especially the travel industry is suffering, but many other industries will follow. As cash flows are much lower than expected, companies get stuck in a liquidity crisis.

The lack of liquidity increases risks for financial stability. If firms default on loans at a large scale, banks could no longer meet their liquidity obligations. In the worst case, this could lead to a systemic bank failure – memories of Lehman Brothers are coming back. 

To prevent this from happening, central banks and governments are making cheap money available at almost zero interest rates. They also buy securities to pump money into the financial system. This “quantitative easing” increases the money supply. 

Now that more money is available, some fear that prices could rise because the equilibrium between the money supply and the amount of goods available in the economy might get off balance. 

Consumer and asset prices: Understanding the difference 

When it comes to inflation, there is a major difference between consumer and asset prices. Consumer prices – for example the price of bread – have hardly increased at all in recent years. Quite the opposite: Since the 2008 financial crisis, the central banks of the USA and the Eurozone have had to fight off deflationary tendencies. 

One reason is that the circulating money supply has remained stable in recent years despite quantitative easing. In times of economic uncertainty, banks are hesitant to issue loans, meaning the central bank money never actually reaches the real economy. 

Also, consumer prices depend more on confidence in the currency than on the money supply. If consumers trust in the value of money, companies cannot easily increase their prices without losing sales.

The picture looks different in financial markets: Asset prices have gone up massively in recent years. The S&P 500 has grown by almost 300% in the 10 years following the financial crisis. In many countries, real estate is also vastly overvalued in comparison to purchasing power and wage inflation. The resulting financial bubbles are a danger for financial stability.

Cryptocurrencies as insurance for a systemic failure

Back to the initial question: Do we need to fear inflation? 

In the case of consumer prices, not really. We won’t have to buy bread with a bag full of cash anytime soon. However, quantitative easing might weaken confidence in the currency. In the long-term, this could indeed lead to rising inflation in the form of a self-fulfilling prophecy. 

In terms of asset prices, however, quantitative easing is a concern. Inflated asset prices can cause sudden market downturns (like now) and it becomes more difficult to forecast future prices. As a result, investments are increasingly becoming a lottery. 

That’s why the fear of decreasing financial stability could lead to increased demand for cryptocurrencies in the long term, as they are mostly independent of monetary policy. The main question here is whether investors believe in cryptocurrencies as a reliable store of value. If so, cryptocurrencies could find their place in the portfolio of conservative investors as insurance against systemic failure.