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How Monetary Policies Affect the Global Cryptocurrency Market
2021-06-09, 06:13
Analysts generally believe that during the pandemic, the pump-priming policy of the Federal Reserve is conducive to our current bull market. A large amount of new money was unable to be invested in the real economy, so it turned to the cryptocurrency market for higher investment returns. It was the driving force behind the rise of cryptocurrency prices. Before April this year, investors and analysts took pump-priming as good news for the crypto-digital currency market. The Biden administration released $6 trillion dollars late May this year, but the cryptocurrency market was not as hot as expected. People sold their coins out instead.
What exactly is pump priming? Why do we need it? Why is the cryptocurrency market so sensitive to the dollar policy? Why is the cryptocurrency market so cloudy about pump priming? The following article will answer these questions.
What Is Pump Priming?
In layman's terms, the term refers to an increase in the money supply. There are generally two ways for the government to achieve pump priming.
First, through fiscal policy. By increasing the government's fiscal deficit, we can increase the money supply. The Biden administration's $6 trillion budget proposal is a typical example. Since the epidemic, Biden has already implemented a round of fiscal stimulus packages. In addition to the $1.9 trillion stimulus package, we have another $2.3 trillion to support employment programs and $1.8 trillion for the "American Families Plan”. If the bill is passed, it means that the U.S. government expenditure in 2022 reached 6 trillion. The U.S. government budget deficit in 2022 will reach 1.84 trillion dollars. That is, the U.S. government will carry 1.84 trillion dollars of debt in 2022. These debts, however, will be purchased by the Federal Reserve through the issuance of additional money. By buying government debt, the Federal Reserve puts into the market the new money.
From: www.bwchinese.com
Second, through monetary policy. To understand how monetary policy primes the pump, we need to first take a look at the modern coin issuance system. Governments issue physical money as the most basic form of money in the modern monetary system through central banks. The central bank, in turn, gives this base money to commercial banks which release it to the market for lending. In this process, the actual amount of lending by commercial banks will be much higher than the amount of base money received from the central bank. This is because commercial banks will lend out the base money after getting it. Residents and institutions will deposit it into banks after acquiring it through transactions, and banks can further use these deposits to lend out credit again, thus achieving multiplier-level money creation. In the modern money creation system of government-central bank-commercial banks, the central bank can control the money supply by regulating several key indicators through monetary policy.
From: BohatALA
Deposit reserve ratio. To help commercial banks cope with a run, the central bank usually does not allow commercial banks to lend out all the deposits and loans, but must keep a certain amount of funds in reserve in order to cope with customer withdrawals and liquidation needs. The ratio of such funds is called the reserve requirement ratio. A lower reserve requirement ratio means that commercial banks have more funds to lend out, which in turn increases the money supply.
Rediscount rate. The central bank sometimes provides collateralized loans to commercial banks, and the interest rate at which the central bank provides loans to commercial banks is the rediscount rate. A reduction in the rediscount rate by the central bank increases the total amount of loans that commercial banks can borrow from the central bank. In this way. it increases the amount of funds available to commercial banks, which in turn increases the money supply.
Interest rates. Commercial banks' deposit rates and lending rates are regulated by the central bank. A reduction in lending rates will allow more customers to borrow money from the banks, which increases the total amount of loans and the money supply.
Why Is It Necessary to Implement Pump Priming?
The goal is to stimulate economic growth. But how does the increase in the money supply contribute to economic growth? Let's briefly explain the rationale with this BBC diagram of the quantitative easing process. First, the central bank prints money and releases it into the market by buying bonds (including but not limited to treasuries). The interest rate can be understood as the face value of the money. It falls when the supply of money is greater than the demand for money. In the short term, the demand for money is fixed, and the money in circulation will increase the supply of money, leading to a fall in the interest rates.
From: BBC
The fall in interest rates affects the behavior of residents and businesses in two ways: first, residents and businesses will take more money out of the bank and put it into consumption and investment. Second, with the fall in lending rates, residents and businesses will choose to borrow more money from banks for consumption and investment. The increase in consumption and investment will directly stimulate economic development, creating more jobs and economic output.
However, the above process is only an ideal model of the economic impact of pump priming. Instead of stimulating the economy, the actual policy may cause many side effects, such as asset price bubbles, excessive inflation, etc., and even aggravate the economic recession. Since there is a risk that such a policy may backfire, why do governments, especially the U.S. government, still use it to stimulate economic growth to get out of recession? This is because the economic operation is very complex and difficult to control, and the government has no other more effective and direct way to regulate it.
How Does Pump Priming Affect the Cryptocurrency Market
There is no doubt that the current bull run in the crypto market is inextricably linked to the US government's pump priming. In late 2020, the cryptocurrency market saw the start of this bull market as the dollar supply increased and the dollar exchange rate weakened. Bitcoin achieved more than 10% rise in a single day frequently, and DeFi on Ethereum took off, increasing Ether value, even more than the value of Bitcoin. In contrast, other cryptocurrency prices also went up, reaching the highest price in history. In May 2021, when Biden proposed to increase the dollar supply by increasing government debt again, the price of Bitcoin fell by more than 5% in a single day. The market's cloudy attitude towards the dollar was influenced by two main factors: the Pandemic and investors' ambiguous attitude towards cryptocurrencies.
In the late 2020s, the pandemic severely affected the world’s economic development. The real economy of many countries, including that of the U.S., came to a standstill. During this period, in order to promote economic development and prevent a large-scale recession, the U.S. government chose a quantitative easing policy to release a large number of dollars into the market. When a large amount of dollars entered the market, residents and enterprises would generally choose to inject a large amount of capital into the real economy to obtain a higher rate of return on capital. But affected by the epidemic, the real economy is weak with an unsatisfying rate of return. At the same time, the massive printing of dollars and the stagnation of the U.S. economy both dealt a serious blow to the international status of the U.S. dollar. The exchange rate of the U.S. dollar continued to weaken, and the market began to doubt the authority of the U.S. dollar. At this time, cryptocurrencies, which have both monetary properties and virtual economic products, were favored by investors. A large amount of money that should have been invested in the real economy flowed into the cryptocurrency market. It was against the background of investors' pursuit of high yields and skepticism of the U.S. dollar. At this point, Bitcoin's cryptocurrency properties became a key factor in its attraction to investment.
By May 2021, the total cap of the cryptocurrency market reached a new peak. At this point, with the popularization of vaccines and the global containment of the pandemic, investors began to focus on the recovery speed of the real economy. During the first six months of the bull market, Bitcoin's property as a currency was gradually downplayed by investors. Instead, it was increasingly used as an alternative investment to hedge risk. It is also in the first half of 2021 that the cryptocurrency market has seen more institutional investors. While they typically cross-hold investments from different financial markets, institutional investors have increased the correlation between the cryptocurrency market and other financial markets.
Before the Biden administration made the budget proposal public in May, the U.S. economic data in April showed that the recovery level of the U.S. economy did not meet expectations. The CPI index increased by 0.8% YoY, with a sharp increase in inflationary pressure. Against such a backdrop, the Biden administration's pump priming was interpreted as a desperate move to stimulate economic development. Some analysts also believed that the program would seriously increase inflationary pressure in U.S. society. Under the high inflationary pressure, investors' risk-taking ability becomes worse, so they start to care more about value-keeping of their investments as well as the ability to counteract risks. They pull their money out of the crypto market and shift to other less-risky investments with which they are more familiar. Therefore, Biden's fiscal budget proposal increases the investors’ incentive to sell cryptocurrencies.
Conclusion
For a long time, cryptocurrencies like Bitcoin were once treated as a new type of standalone investment because of their low correlation to traditional finance and economics. Today, the influence of traditional economic indicators and policies on Bitcoin prices appears to be growing. The impact of CPI, the dollar exchange rate, and U.S. fiscal policy on the cryptocurrency market can be significant and profound. Whether investors see cryptocurrencies as a substitute for trading currencies or as a risky investment, they cannot invest without observing macroeconomic indicators and interpreting economic policies.
Author: Gate.io Researcher: Charles. F
*This article represents the views only of the researcher and does not constitute any investment advice.
This article is original and owned by Gate.io. Legal sanctions shall apply if used without reference.
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