The Bitcoin Halvening: A Deflationary Cycle & Price Catalyst

Every four years, the Bitcoin blockchain undergoes what is popularly known as “the halvening” or “the halving” event: A fundamental event where BTC's distribution rate is cut in half.

Initially, when Bitcoin was launched in 2009, miners were rewarded 50 bitcoins for each block they added to the chain. However, every 210,000 blocks or approximately every four years, this reward is technically designed to halve, giving the naming convention for Bitcoin’s most important fundamental event, “the halvening.”

The above supply mechanism is core for Bitcoin’s design, and the diminishing rate of distribution of BTC into the network is what ensures a lower inflation rate of Bitcoin every four years.

Since its inception, Bitcoin has undergone three halving events already, and the next is expected sometime in April 2024, when the block reward will be reduced to 3.125 BTC.

Bitcoin’s Deflationary Monetary Policy

The strict rules for Bitcoin’s supply dynamics are all hard-coded into its design, making it impossible to change them. Bitcoin’s embedded monetary policy dictates there can only ever be 21 million Bitcoins in total. At the time of writing, over 19.3 million of that total supply has already been mined; the last block will be mined at around 2140.

However, as long as there’s still BTC to be released, the network will naturally experience inflation. The inflation rate of Bitcoin is calculated by how fast the total supply of BTC is growing on a yearly basis. When the halving cuts the rate of supply by half, the inflation rate drops significantly every four years.

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This is one of the reasons why some people see Bitcoin as a kind of "digital gold" because it becomes scarcer over time, similar to gold.

The Harder the Asset, the Lower the Inflation

Bitcoin stands in sharp contrast to national currency, which follows an inflationary model. Essentially, all fiat currencies can increase in supply at an indefinite level, which, from an inflation perspective, makes them much softer assets than Bitcoin.

For instance, in 2020, the U.S. government increased the monetary supply fourthfold, which led to an increase in inflation rates, ultimately eroding the purchasing power of each dollar in circulation.

Bitcoin - Scarcer than Gold

Bitcoin is sometimes labeled "digital gold," and there's a good reason for that. Both gold and Bitcoin share a fundamental characteristic: scarcity. Gold, a precious metal highly valued for centuries, is finite in supply, with only a limited amount available on Earth. Similarly, Bitcoin's supply is capped at 21 million coins, making it the first digital asset with a predefined and fixed maximum supply.

Comparing the attributes of gold and bitcoin can be done in a number of ways. A popular model to measure the scarcity of commodities is using the Stock-to-Flow model (SF). SF is a ratio that compares the existing supply (stock) of an asset to the amount of new supply (flow) that is being added to it over time.

The SF ratio is calculated by dividing the stock by the flow. The higher the SF ratio, the scarcer the asset is considered to be. A high SF ratio indicates that it would take a long time to replace the existing supply with a new supply at the current production rate.

In this simplified example, the SF ratio for gold increases slightly from around 57.83 in 2022 to around 69.68 in 2032. This increase is due to a small increase in the stock of gold (existing supply), while the annual production is expected to remain relatively constant at around 3,500 metric tons per year.

As evident here, Bitcoin currently is just about as scarce as gold in 2022, following its SF ratio. However, in the year 2032, Bitcoin will have gone through 2 additional halving events (2024 and 2030), which will decrease the daily flow of BTC to 225, bringing its SF up to 251, making Bitcoin a multitude more scarce than gold.

Criticisms of the S2F Model

While the stock-to-flow model is recognized for its use to distinguish a correlation between the scarcity of an asset and its price, there are naturally other elements other than supply-side factors, such as flow and stock, that influence the price of an asset. For an asset like bitcoin without intrinsic properties like gold, the demand side factors are equally important.

The Bitcoin Halving - A Catalyst for Price?

The main reason why the halving event catches so much attention from Bitcoin investors is because of its historical positive influence on price discovery.

Simply put, if the “supply” of new bitcoin decreases and the demand for BTC remains constant or increases, laws of supply and demand dictate that the price will go up.

Bitcoin adopters have been very aware of this fact early on. Hal Finney, the second user of Bitcoin ever, even commented in 2011 about the future price expectancy of BTC:

“As an amusing thought experiment, imagine that Bitcoin is successful and becomes the dominant payment system in use throughout the world. Then, the total value of the currency should be equal to the total value of all the wealth in the world. Current estimates of total worldwide household wealth that I have found range from $100 trillion to $300 trillion. With 20 million coins, that gives each coin a value of about $10 million.”

- Hal Finney.

Halving Event: Historically Good for Price Discovery

BTC's price has historically always rallied to all-time highs about a year to a year and a half after each halvening event. Even modeling the price development 100 days after the halving event, there has been a clear precedent for price surges.

The question naturally always remains whether historical behavior can be indicative of how the future will unfold. As is the case with any future predictive model, the outcome is pegged to probability, and using historical data to predict future prices will always entail great uncertainty.

That said, if Bitcoin is on your radar as an investment objective, it might be wise to consider how a significant contraction in the rate of supply will influence the price of BTC moving forward.

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