Bitcoin is only a medium of exchange when merchants accept it and hold onto it. Right now merchants are dumping bitcoin for dollars, so its not being used as a medium of exchange. This btw. also throws the transaction cost benefit argument right out of the window (spread).
Now will merchants ever accept bitcoin and hold onto them?
No.
This is where you lost me. The merchants don't have to hold onto the BTC for bitcoin to have been used as a medium of exchange. The BTC purchaser exchanged their bitcoins for a product regardless of the actions of the merchant after the fact.
The idea is that at first most merchants immediately convert 100% to fiat currencies as hopefully more and more merchants adopt bitcoin (users of bitcoin driving the economy forward). At some point enough players are accepting bitcoins for payment that some merchants can afford to keep some percentage of sales in BTC to then pay suppliers or for services necessary for their business (merchants driving the economy forward). This then cycles and continues to grow the bitcoin economy in a positive re-inforcement loop that ideally ends with majority of participants only converting small percentages to fiat or none at all. It all has to start where we are now though.
Not to say that things will actually evolve like that, nobody knows how far this new economy will grow. However I think it's a bit myopic to completely rule out fiat convert merchant adoption today as any sort of potential progress and conclude it's game over. This is the first part of the process, we'll know if it works or not with time.