Tightening Monetary Policy Threatens Decentralized Finance and Crypto

Central banks are plotting to taper their balance sheets by as much as $410 billion for the rest of 2022 to deal with worsening inflation. The downside of this move could see crypto markets experience a decline in prices as they grapple with the new realities of monetary policy.

Analysts at Bloomberg Economics have highlighted a pattern among the Group of Seven (G7) countries in tightening their monetary policies. The report noted that central banks are shrinking their balance sheets and increasing interest rates.

In the past, the U.S. Federal Reserve reduced its balance sheets alone but this time, other central banks are likely to follow suit.

The Bank of England (BoE) has already started shrinking its holdings with a hike in interest rates likely this month. And the Bank of Canada and the European Central Bank have revealed a timeline to begin quantitative tightening of their financial markets.

Last year, the central banks of the G7 added $2.8 trillion as part of efforts to stimulate the recovery of their economies after the effects of the COVID-19 pandemic. 

However, in March the Consumer Price Index (CPI) climbed by 7.9%, making it the fastest growth in annual inflation in nearly 40 years.

DeFi might suffer from shift in monetary policy

In order to combat inflation, central banks are ditching the policy of quantitative easing but financial markets are feeling the pangs of the move.

“This is a major financial shock for the world,” said Alicia Garcia Herrero, head economist at Natixis. “You are already seeing the consequences of tapering in reduced dollar liquidity and dollar appreciation.”

Cryptocurrency markets and DeFi are also affected by the new policy moves by central banks. Despite the purchases by MicroStrategy and the Luna Foundation Guard, bitcoin (BTC) and other cryptocurrencies are still experiencing a pause in prices. This signals the increasing correlation between crypto and traditional financial markets.

Bitcoin is trading at $38,843 while the global crypto market cap sits at $1.74 trillion. According to data from Defi Pulse, the total value locked (TVL) in DeFi projects is at $75 billion compared to the highs of 87 billion in Feb. Experts have noted that the actions of the Fed and other central banks have “made it difficult to take on risk” in the markets.