The Interaction between Cryptocurrency and Monetary Policy

The rise of cryptocurrencies, facilitated by the advancement of clever digital technology, may pose a threat to the monopoly of official central bank-controlled currencies.

Cryptocurrencies are rapidly being seen as genuine currencies capable of serving as mediums of trade.

About the Fed

Founded in 1913, the Fed is entirely autonomous and is neither influenced or dependent on the US government. This is the only organization in the world that has the authority to print USD (US dollars).

The Fed not only has ultimate control over the US economy, but they also possess a substantial impact on the crypto industry. Almost always, the Fed meets roughly eight times a year to alter and maintain policies, as well as to promote monetary stability and flexibility. Every time the meeting takes place, the price of tokens and coins will fluctuate, more or less.

With ultimate rights, the Fed can make changes in interest rates. They change it to do inflation control.  When interest rates rise, both firms and consumers may have a tendency to cut back on spending. Earnings fall and stock prices drop will happen as a result. On the other hand, when interest rates have declined considerably, consumers and corporations will boost spending, leading stock values to rise.

To keep price inflation in line, the Fed can raise the federal funds rate using its monetary policy tools. In this instance, monetary policy is said to "tighten," or to become more "contractionary" or "restrictive." 

Specifically, The Fed may use these methods to decrease the federal funds rate in order to mitigate or reverse economic downturns and bolster inflation. Then the monetary policy is said to "ease," or to become more "expansionary" or "accommodative" to lower the federal funds rate. 

The Fed has generally conducted monetary policy by using three tools: Reserve Requirements, The discount rate, and Open market operations. The Federal Open Market Committee (FOMC) is responsible for implementing Open market operations, while the Board of Governors looks after The discount rate and Reserve requirements.

In 2008, the Fed expanded its monetary policy toolkit by paying interest on reserve balances stored at Reserve Banks. Recently, the Fed implemented overnight reverse repurchase agreements to sustain the federal funds rate level.

The Federal Reserve, the United States central bank, employs a range of techniques to implement monetary policy. These tools include the reserve requirements required by member banks, changes in interest rates, and open market operations, which entail the purchase of Treasuries and other securities.

Crypto and Monetary Policy

Cryptocurrencies now coexist with traditional currencies. Current volumes are minimal and do not threaten the dominance of official money as the primary currency. However, if algorithms develop to reduce cryptocurrency volatility, their popularity and use may grow.

At a financial conference in 2017, a vice chair of the U.S. Federal Reserve Bank, Randal Quarles said, “While these digital currencies may not pose major concerns at their current levels of use, more serious financial stability issues may result if they achieve wide-scale usage.” He contends that the availability of an alternative asset such as Bitcoin during times of economic difficulty may thwart efforts to reduce pricing and credit risk since the US dollar's exchange rate may become unstable.

But let's take the case of Venezuela, where monetary mismanagement has caused misery and insecurity for its people. We have seen many Venezuelans of various socioeconomic backgrounds turn to Bitcoin and other cryptocurrencies to shield themselves from the ravages of severe inflation and bad government. In this economic climate, cryptocurrencies can be a lifeline for families in need of a more solid store of value.

Instead of constituting a threat, the cohabitation of government money and cryptocurrencies can have a good impact by acting as a deterrent to central banks. This is a partial justification of Hayek's (1976) argument for abolishing the governmental monopoly on money in order to maintain the stability of the official currency.

Looking at the current market drop, it is clear that the Fed rate rises have had a substantial influence on Bitcoin and the crypto market in general. Many have asserted that Bitcoin is a hedge against inflation due to its limited supply and a safe haven for investors, but we can now observe Bitcoin's price moving in the same direction as other risky assets, such as stocks, etc.

It can be shown that cryptocurrencies have the same market responses as other risky assets whenever the Fed indicated that it would begin raising or lowering its bond purchases, as well as offering hints that interest rates would be raised the next year.

In the short term, cash flows will frequently shift away from high-risk investment channels (such as the cryptocurrency, stock, and real estate markets) and into less risky investment channels (such as bank deposits).

Following that, an increase in interest rates causes many firms to pay greater interest on loans, reducing their earnings and stock values. Businesses will now face economic pressure, forcing them to raise prices for their goods and services. As a result, users will have to pay more to buy or utilize the goods for their own requirements.

Central bank tightening is perhaps the most important macro problem driving both the stock and cryptocurrency markets today, which explains the remarkable connection between these two industries.