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Federal Reserve’s Pursuit of ‘Inverted Wealth Effect’ Is Undermining Crypto

The Federal Reserve’s strategy to raise interest rates may continue, making it difficult for the crypto industry to rebound. For crypto assets to become an inflation hedge, the industry needs to explore ways to decouple crypto from traditional markets. Decentralized finance (DeFi) can perhaps offer a way out by breaking with traditional financial models.

How Federal Reserve Policies Affect Crypto

In the 1980s, Paul Volcker, the chairman of the Federal Reserve Board, introduced the policy of raising interest rates to control inflation. Volcker raised interest rates to over 20%, plunging the economy into a recession by reducing people’s ability to buy. 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 drive down high inflation rates.

In 2022, underlying inflation in the United States reached its highest level in 40 years, forcing the Federal Reserve to constantly raise interest rates throughout the year. This had a negative impact on the crypto market. Mike McGlone, senior commodities strategist at Bloomberg Intelligence, explained that the Fed’s “sledgehammer” has “pressured crypto this year.” McGlone thinks Fed 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 declines in cryptocurrency prices. For example, bitcoin (BTC) prices fell on May 6 after the May 3-4 Fed meeting to raise interest 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 June rate hike was a big factor for cryptocurrencies like BTC and Ether (ETH) to drop 70% from their all-time highs. As the price charts show, the policies of the Federal Reserve have a direct correlation with the volatility of the crypto market. This uncertainty is preventing the crypto industry from making a definitive comeback. Since cryptocurrencies are a risky asset class, investors are reducing their exposure to crypto due to rising interest rates and fears of recession.

The Federal Reserve raised interest rates another 0.75% in November. The Fed Said It was trying to bring down “inflation at the rate of 2% over the long term”. The Fed Committee will continue to raise the fed funds rate to 3-4%. It “expects that continued increases in the target range will be appropriate to achieve a monetary policy stance tight enough to bring inflation down to 2% over time.”

Related: Jerome Powell prolongs our economic agony

With inflation still 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 risky assets like cryptocurrencies.

The Future Trajectory of Fed Policies

In all likelihood, the Federal Reserve will continue to hike interest rates in line with market data feedback. Bank of America wrote, “The Fed will emphasize reliance on data […] they will get two more NFP and CPI impressions before the [December] Meet; if they stay hot an additional 75 bps are in the cards, otherwise a 50 bps deceleration is possible. The strategists added, “The Fed isn’t done until the data says it is.”

Echoing this sentiment, Barclays’ credit research team said: “The Fed needs to see inflation turn…before it turns significantly dovish.” So there is a good chance that even if the Federal Reserve reduces the percentage hike, it will continue to raise interest rates. According to the inflation figures, the Fed may slow down its liquidity tightening measures from December but will not stop immediately with its inflation-mitigation strategies. Thus, investors should be prepared for a long period of volatility in the crypto market.

Related: The Market Isn’t Up Anytime Soon – So Get Used To The Dark Times

The Federal Reserve intends to create an inverted wealth effect so that investors revalue their crypto portfolio. They want to create a precarious market situation by slowing down demand but also make sure to avoid any chaos. Despite US GDP shrinking for two straight quarters, the Fed is eager to assess and implement painful policies. Thus, the crypto industry needs to find alternative methods to meet the Fed’s challenge.

The current market scenario demonstrates that the prices of crypto assets are closely tied to stock and market markets. Investors still view them as high-risk assets and are skeptical of investing in times of high inflation. It is therefore imperative that the crypto sector distances itself from other traditional risky asset classes. Fortunately, a report from the US central bank suggests that the perception of risk towards crypto is gradually changing.

According to a report by the Federal Reserve Bank of New York, cryptocurrencies are no longer in the top 10 most cited as potential risks for the US economy. This reveals a significant shift in the mindset of investors, demonstrating 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 defeat inflation and offset Fed policies, the crypto industry must embrace decentralized finance for a robust future economy.

Bernd Stockl is the 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 to be and should not be considered legal or investment advice. The views, thoughts and opinions expressed herein are those of the author alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.

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