The Federal Reserve’s strategy of raising interest rates may continue, making it difficult for the crypto industry to bounce back. For crypto assets to become a hedge against inflation, the industry must find ways to decouple crypto from traditional markets. Decentralized finance (DeFi) may offer a way out of legacy financial models.
How Federal Reserve Policy Affects Crypto
In the 1980s, Paul Volcker, chairman of the Federal Reserve System, introduced the policy of raising interest rates to control inflation. Volcker raised interest rates to 20%, forcing the economy into recession, reducing people’s purchasing power. The strategy worked and the consumer price index (CPI) fell from 14.85% to 2.5%. Even now, the Federal Reserve continues to use the same methodology to bring down high rates of inflation.
In 2022, US core inflation reached a 40-year high, prompting the Federal Reserve to raise interest rates consistently throughout the year. This has negatively hit the crypto market. Bloomberg Intelligence commodity strategist Mike McGlone explained that the Fed’s “hammer” is “suppressing crypto this year.” McGlone believes the Fed’s policies could lead to a crash worse than the 2008 financial crisis.
Market data shows a clear pattern where Federal Reserve interest rate hikes correspond with significant falls in cryptocurrency prices. For example, Bitcoin (BTC) prices fell on May 6 following the Fed’s May 3 and 4 meeting to raise interest rates by 0.5%. Similarly, Bitcoin fell to $17,500 after the Fed meeting on June 14th and 15th, where they raised rates by 0.75%.
The interest rate hike in June was a significant factor in cryptocurrencies such as BTC and Ether (ETH) dropping 70% from their all-time highs. As price charts show, Federal Reserve policy is directly related to crypto market volatility. This uncertainty is preventing the crypto industry from making an eventual comeback. Since cryptocurrencies are a risky asset class, investors are reducing their exposure to crypto due to fears of rising interest rates and recession.
The Federal Reserve raised interest rates by another 0.75% in November. The Fed has said it is trying to keep “inflation below 2 percent over the long term.” The Fed Committee will continue to raise federal funds rates to 3-4%. It “expects that continued increases in the target range will be appropriate to achieve a monetary policy stance that is sufficiently restrictive to return inflation to 2 percent over time.”
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With inflation remaining high, there is little reason to believe the Federal Reserve will stop raising interest rates anytime soon. Unfortunately, this is not good news for risky assets like cryptocurrencies.
The future trajectory of Fed policy
Most likely, the Federal Reserve will continue to raise interest rates, according to market data. Bank of America wrote: “The Fed will focus on data addiction […] they will get two more NFP and CPI prints before then [December] a meeting if they stay hot, another 75bps is on the cards, if not, a slowdown to 50bps is possible.” The strategists added that “the Fed isn’t done hiking until the data says so.”
Echoing this sentiment, Barclays’ credit research team said: “The Fed needs to see inflation turn around … before easing meaningfully.” So there is a good chance that even if the Federal Reserve lowers the rate of growth, they will continue to raise interest rates. Depending on inflation numbers, the Fed may slow its liquidity tightening measures from December, but will not immediately end its deflationary strategies. Thus, investors should ensure the long period of volatility in the crypto market.
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The Federal Reserve intends to create a reverse wealth effect for investors to re-evaluate their crypto portfolios. They want to create an unstable market situation by slowing demand, but also be careful to avoid any chaos. Despite two consecutive quarters of contraction in US GDP, the Fed is keen to assess and implement painful policy. Thus, the crypto industry must find alternative methods to meet the Fed’s challenge.
The current market scenario shows that crypto asset prices are intertwined with the stock and stock markets. Investors still see them as high-risk assets and are skeptical about investing during periods of high inflation. Thus, it is imperative for the crypto sector to stay away from traditional risky asset classes. Fortunately, the US central bank’s report shows that risk perception towards crypto is gradually changing.
According to a report by the Federal Reserve Bank of New York, cryptocurrencies are no longer among the top 10 most cited potential risks to the US economy. This reveals an important shift in investor mindset, indicating that crypto will eventually become a risk-free asset class. But that won’t happen if crypto continues to follow the legacy financial model. To beat inflation and offset Fed policy, the crypto industry must embrace decentralized finance for a robust future economy.
Bernd Stoeckl Co-founder and Chief Product Officer of Palmswap, a decentralized perpetual contract trading protocol.
This article is for general informational purposes and is not intended and should not be construed as legal or investment advice. The views, thoughts and opinions expressed herein are solely those of the author and do not necessarily reflect or represent the views and opinions of Cointelegraph.