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 the hedge against inflation, the industry needs to explore ways to decouple crypto from traditional markets. Decentralized finance (DeFi) may offer a way out by breaking away from old financial models.
How Federal Reserve policy affects crypto
In the 1980s, Paul Volcker, the chairman of the Federal Reserve Board, introduced the rate hike policy to control inflation. Volcker raised interest rates to over 20%, pushing the economy into recession by 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 inflation rates.
In 2022, US core inflation hit a 40-year high, prompting the Federal Reserve to consistently raise interest rates throughout the year. This has negatively affected the crypto market. Mike McGlone, the Senior Commodity Strategist at Bloomberg Intelligence, explained that the Fed’s “sledgehammer” has “put pressure on crypto this year.” McGlone believes the Fed’s policy could lead to a crash worse than the 2008 financial crisis.
Market data shows a clear pattern where the Federal Reserve’s interest rate hikes match significant declines in cryptocurrency prices. For example, Bitcoin (BTC) prices fell on May 6 after the Fed meeting on May 3-4 to raise interest rates by 0.5%. Similarly, Bitcoin fell to $17,500 after the Fed meeting on June 14-15 where they raised interest rates by 0.75%.
The rate hike in June was a major factor for cryptocurrencies like BTC and Ether (ETH) to drop 70% from their all-time highs. As the price charts show, Federal Reserve policy has a direct correlation to crypto market volatility. This uncertainty is hindering the crypto industry from making a definitive comeback. Since cryptocurrencies are a high-risk asset class, investors are reducing their exposure to crypto due to rising interest rates and recession fears.
The Federal Reserve hiked interest rates again by 0.75% in November. The Fed said it was trying to “cut inflation by 2 percent over the long term.” The Fed Committee will continue to raise the federal fund rate to 3-4%. It “anticipates that sustained increases in the target range will be appropriate to achieve a monetary policy stance sufficiently restrictive to reduce inflation to 2% over time.”
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As inflation remains high, there is no reason to believe that the Federal Reserve will stop raising interest rates anytime soon. Unfortunately, this is not good news for high-risk assets such as cryptocurrencies.
The future trajectory of Fed policy
In all likelihood, the Federal Reserve will continue its rate hikes in line with market data feedback. Bank of America wrote, “The Fed will emphasize data dependency […] they get two more NFP and CPI prints before the [December] meeting; if they stay warm, another 75 fps is ahead, if not, a delay of up to 50 fps is possible.” The strategists added, “The Fed isn’t done hiking until the data says so.”
Echoing the sentiment, the Barclays credit research team said, “The Fed needs to see inflation reverse … before it becomes meaningfully easing.” So there is a good chance that even if the Federal Reserve lowers the rate of increase, they will continue to raise interest rates. Depending on the inflation numbers, the Fed could slow down its liquidity-absorbing measures from December onwards, but will not immediately stop its inflation-reducing strategies. So investors should brace themselves for a 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 reassess their crypto portfolio. They want to create a precarious market situation by slowing demand, but also be careful to avoid chaos. Despite US GDP contracting for two quarters in a row, the Fed is eager to evaluate and implement painful policies. So the crypto industry must find alternative methods to meet the Fed challenge.
The current market scenario shows that crypto asset prices are intertwined with the stock and stock markets. Investors still view them as high-risk assets and are skeptical about investing during periods of high inflation. So it is imperative that the crypto sector moves away from other traditional risky asset classes. Fortunately, a report from the US central bank suggests that risk perceptions towards crypto are gradually changing.
Cryptocurrencies are no longer among the top 10 most cited potential risks to the US economy, according to a report from the Federal Reserve Bank of New York. This reveals a major change in investor mindset, demonstrating that crypto will eventually become a non-risky asset class. But that will not happen if crypto continues to follow the old financial model. To beat inflation and offset Fed policy, the crypto industry must embrace decentralized finance for a robust economy going forward.
Bernd Stockl is the co-founder and chief product officer of Palmswap, a decentralized trading protocol for perpetual contracts.
This article is for general information purposes and is not intended to and should not be construed as legal or investment advice. The views, thoughts and opinions expressed here are those of the author alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.