In his blog, The bond roller coaster, John looks at the pricing of government bonds and details how, in recent times, governments wishing to borrow by issuing new bonds are having to offer higher coupon rates to attract investors. The interest rate hikes by central banks in response to global-wide inflationary pressures have therefore spilt over into bond markets. Though this evidences the ‘pass through’ of central bank interest rate increases to the general structure of interest rates, it does, however, pose significant costs for governments as they seek to finance future budgetary deficits or refinance existing debts coming up to maturity.
The Autumn Statement in the UK is scheduled to be made on 22 November. This, as well as providing an update on the economy and the public finances, is likely to include a number of fiscal proposals. It is thus timely to remind ourselves of the size of recent discretionary fiscal measures and their potential impact on the sustainability of the public finances. In this first of two blogs, we consider the former: the magnitude of recent discretionary fiscal policy changes.
First, it is important to define what we mean by discretionary fiscal policy. It refers to deliberate changes in government spending or taxation. This needs to be distinguished from the concept of automatic stabilisers, which relate to those parts of government budgets that automatically result in an increase (decrease) of spending or a decrease (increase) in tax payments when the economy slows (quickens).
The suitability of discretionary fiscal policy measures depends on the objectives they trying to fulfil. Discretionary measures can be implemented, for example, to affect levels of public-service provision, the distribution of income, levels of aggregate demand or to affect longer-term growth of aggregate supply. As we shall see in this blog, some of the large recent interventions have been conducted primarily to support and stabilise economic activity in the face of heightened economic volatility.
Discretionary fiscal measures in the UK are usually announced in annual Budget statements in the House of Commons. These are normally in March, but discretionary fiscal changes can be made in the Autumn Statement too. The Autumn Statement of October 2022, for example, took on significant importance as the new Chancellor of the Exchequer, Jeremy Hunt, tried to present a ‘safe pair hands’ following the fallout and market turbulence in response to the fiscal statement by the former Chancellor, Kwasi Kwarteng, on 23 September that year.
The fiscal impulse
The large-scale economic turbulence of recent years associated first with the global financial crisis of 2007–9 and then with the COVID-19 pandemic and the cost-of-living crisis, has seen governments respond with significant discretionary fiscal measures. During the COVID-19 pandemic, examples of fiscal interventions in the UK included the COVID-19 Business Interruption Loan Scheme (CBILS), grants for retail, hospitality and leisure businesses, the COVID-19 Job Retention Scheme (better known as the furlough scheme) and the Self-Employed Income Support Scheme.
The size of discretionary fiscal interventions can be measured by the fiscal impulse. This captures the magnitude of change in discretionary fiscal policy and thus the size of the stimulus. The concept is not to be confused with fiscal multipliers, which measure the impact of fiscal changes on economic outcomes, such as real national income and employment.
By measuring fiscal impulses, we can analyse the extent to which a country’s fiscal stance has tightened, loosened, or remained unchanged. In other words, we are attempting to capture discretionary fiscal policy changes that result in structural changes in the government budget and, therefore, in structural changes in spending and/or taxation.
To measure structural changes in the public-sector’s budgetary position, we calculate changes in structural budget balances.
A budget balance is simply the difference between receipts (largely taxation) and spending. A budget surplus occurs when receipts are greater than spending, while a deficit (sometimes referred to as net borrowing) occurs if spending is greater than receipts.
A structural budget balance cyclically-adjusts receipts and spending and hence adjusts for the position of the economy in the business cycle. In doing so, it has the effect of adjusting both receipts and spending for the effect of automatic stabilisers. Another way of thinking about this is to ask what the balance between receipts and spending would be if the economy were operating at its potential output. A deterioration in a structural budget balance infers a rise in the structural deficit or fall in the structural surplus. This indicates a loosening of the fiscal stance. An improvement in the structural budget balance, by contrast, indicates a tightening.
The size of UK fiscal impulses
A frequently-used measure of the fiscal impulse involves the change in the cyclically-adjusted public-sector primary deficit.
A primary deficit captures the extent to which the receipts of the public sector fall short of its spending, excluding its spending on debt interest payments. It essentially captures whether the public sector is able to afford its ‘new’ fiscal choices from its receipts; it excludes debt-servicing costs, which can be thought of as reflecting fiscal choices of the past. By using a cyclically-adjusted primary deficit we are able to isolate more accurately the size of discretionary policy changes. Chart 1 shows the UK’s actual and cyclically-adjusted primary deficit as a share of GDP since 1975, which have averaged 1.3 and 1.1 per cent of GDP respectively. (Click here for a PowerPoint of the chart.)
The size of the fiscal impulse is measured by the year-on-year percentage point change in the cyclically-adjusted public-sector primary deficit as a percentage of GDP. A larger deficit or a smaller surplus indicates a fiscal loosening (a positive fiscal impulse), while a smaller deficit or a larger surplus indicates a fiscal tightening (a negative fiscal impulse).
Chart 2 shows the magnitude of UK fiscal impulses since 1980. It captures very starkly the extent of the loosening of the fiscal stance in 2020 in response to the COVID-19 pandemic. (Click here for a PowerPoint of the chart.) In 2020 the cyclically-adjusted primary deficit to GDP ratio rose from 1.67 to 14.04 per cent. This represents a positive fiscal impulse of 12.4 per cent of GDP.
A tightening of fiscal policy followed the waning of the pandemic. 2021 saw a negative fiscal impulse of 10.1 per cent of GDP. Subsequent tightening was tempered by policy measures to limit the impact on the private sector of the cost-of-living crisis, including the Energy Price Guarantee and Energy Bills Support Scheme.
In comparison, the fiscal response to the global financial crisis led to a cumulative increase in the cyclically-adjusted primary deficit to GDP ratio from 2007 to 2009 of 5.0 percentage points. Hence, the financial crisis saw a positive fiscal impulse of 5 per cent of GDP. While smaller in comparison to the discretionary fiscal responses to the COVID-19 pandemic, it was, nonetheless, a sizeable loosening of the fiscal stance.
Sustainability and well-being of the public finances
The recent fiscal interventions have implications for the financial well-being of the public-sector. Not least, the financing of the positive fiscal impulses has led to a substantial growth in the accumulated size of the public-sector debt stock. At the end of 2006/7 the public-sector net debt stock was 35 per cent of GDP; at the end of the current financial year, 2023/24, it is expected to be 103 per cent.
As we saw at the outset, in an environment of rising interest rates, the increase in the public-sector debt to GDP ratio creates significant additional costs for government, a situation that is made more difficult for government not only by the current flatlining of economic activity, but by the low underlying rate of economic growth seen since the financial crisis. The combination of higher interest rates and lower economic growth has adverse implications for the sustainability of the public finances and the ability of the public sector to absorb the effects of future economic crises.
Articles
- Autumn Statement 2023: When is it and how will it affect me?
BBC News (16/11/23)
- What is the Autumn Statement?
House of Commons Library (13/11/23)
- Putting the fiscal toothpaste back into the tube: It’s time to normalise the euro area fiscal stance in 2024
VoxEU, Niels Thygesen, Roel Beetsma, Massimo Bordignon, Xavier Debrun, Mateusz Szczurek, Martin Larch, Matthias Busse, Mateja Gabrijelcic, Laszlo Jankovics and Janis Malzubris (30/6/23)
- Euro zone should tighten fiscal policy in 2024 to curb inflation, European Fiscal Board says
Reuters, Jan Strupczewski (28/6/23)
- Hutchins Center Fiscal Impact Measure: Federal, State and Local Fiscal Policy and the Economy
Brookings, Eli Asdourian, Louise Sheiner, and Lorae Stojanovic (27/10/23)
Report
- IFS Green Budget
Institute for Fiscal Studies, Carl Emmerson, Paul Johnson and Ben Zaranko (eds) (October 2023)
Data
Questions
- Explain what is meant by the following fiscal terms: (a) structural deficit; (b) automatic stabilisers; (c) discretionary fiscal policy; (d) primary deficit.
- What is the difference between current and capital public expenditures? Give some examples of each.
- Consider the following two examples of public expenditure: grants from government paid to the private sector for the installation of energy-efficient boilers, and welfare payments to unemployed people. How are these expenditures classified in the public finances and what fiscal objectives do you think they meet?
- Which of the following statements about the primary balance is FALSE?
(a) In the presence of debt interest payments a primary deficit will be smaller than a budget deficit.
(b) In the presence of debt interest payments a primary surplus will be smaller than a budget surplus.
(c) The primary balance differs from the budget balance by the size of debt interest payments.
(d) None of the above.
- Explain the difference between a fiscal impulse and a fiscal multiplier.
- Why is low economic growth likely to affect the sustainability of the public finances? What other factors could also matter?
To finance budget deficits, governments have to borrow. They can borrow short-term by issuing Treasury bills, typically for 1, 3 or 6 months. These do not earn interest and hence are sold at a discount below the face value. The rate of discount depends on supply and demand and will reflect short-term market rates of interest. Alternatively, governments can borrow long-term by issuing bonds. In the UK, these government securities are known as ‘gilts’ or ‘gilt-edged securities’. In the USA they are known as ‘treasury bonds’, ‘T-bonds’ or simply ‘treasuries’. In the EU, countries separately issue bonds but the European Commission also issues bonds.
In the UK, gilts are issued by the Debt Management Office on behalf of the Treasury. Although there are index-linked gilts, the largest proportion of gilts are conventional gilts. These pay a fixed sum of money per annum per £100 of face value. This is known as the ‘coupon payment’ and the rate is set at the time of issue. The ‘coupon rate’ is the payment per annum as a percentage of the bond’s face value:
Payments are made six-monthly. Each issue also has a maturity date, at which point the bonds will be redeemed at face value. For example, a 4½% Treasury Gilt 2028 bond has a coupon rate of 4½% and thus pays £4.50 per annum (£2.25 every six months) for each £100 of face value. The issue will be redeemed in June 2028 at face value. The issue was made in June 2023 and thus represented a 5-year bond. Gilts are issued for varying lengths of time from 2 to 55 years. At present, there are 61 different conventional issues of bonds, with maturity dates varying from January 2024 to October 2073.
Bond prices
Bonds can be sold on the secondary market (i.e. the stock market) before maturity. The market price, however, is unlikely to be the coupon price (i.e. the face value). The lower the coupon rate relative to current interest rates, the less valuable the bond will be. For example, if interest rates rise, and hence new bonds pay a higher coupon rate, the market price of existing bonds paying a lower coupon rate must fall. Thus bond prices vary inversely with interest rates.
The market price also depends on how close the bonds are to maturity. The closer the maturity date, the closer the market price of the bond will be to the face value.
Bond yields: current yield
A bond’s yield is the percentage return that a person buying the bond receives. If a newly issued bond is bought at the coupon price, its yield is the coupon rate.
However, if an existing bond is bought on the secondary market (the stock market), the yield must reflect the coupon payments relative to the purchase price, not the coupon price. We can distinguish between the ‘current yield’ and the ‘yield to maturity’.
The current yield is the coupon payment as a percentage of the current market price of the bond:
Assume a bond were originally issued at 2% (its coupon rate) and thus pays £2 per annum. In the meantime, however, assume that interest rates have risen and new bonds now have a coupon rate of 4%, paying £4 per annum for each £100 invested. To persuade people to buy old bonds with a coupon rate of 2%, their market prices must fall below their face value (their coupon price). If their price halved, then they would pay £2 for every £50 of their market price and hence their current yield would be 4% (£2/£50 × 100).
Bond yields: yield to maturity (YTM)
But the current yield does not give the true yield – it is only an approximation. The true yield must take into account not just the market price but also the maturity value and the length of time to maturity (and the frequency of payments too, which we will ignore here). The closer a bond is to its maturity date, the higher/lower will be the true yield if the price is below/above the coupon price: in other words, the closer will the market price be to the coupon price for any given market rate of interest.
A more accurate measure of a bond’s yield is thus the ‘yield to maturity’ (YTM). This is the interest rate which makes the present value of all a bond’s future cash flows equal to its current price. These cash flows include all coupon payments and the payment of the face value on maturity. But future cash flows must be discounted to take into account the fact that money received in the future is worth less than money received now, since money received now could then earn interest.
The yield to maturity is the internal rate of return (IRR) of the bond. This is the discount rate which makes the present value (PV) of all the bond’s future cash flows (including the maturity payment of the coupon price) equal to its current market price. For simplicity, we assume that coupon payments are made annually. The formula is the one where the bond’s current market price is given by:
Where: t is the year; n is the number of years to maturity; YTM is the yield to maturity.
Thus if a bond paid £5 each year and had a maturity value of £100 and if current interest rates were higher than 5%, giving a yield to maturity of 8%, then the bond price would be:
In other words, with a coupon rate of 5% and a higher YTM of 8%, the bond with a face value of £100 and five years to maturity would be worth only £88.02 today.
If you know the market price of a given bond, you can work out its YTM by substituting in the above formula. The following table gives examples.
The higher the YTM, the lower the market price of a bond. Since the YTM reflects in part current rates of interest, so the higher the rate of interest, the lower the market price of any given bond. Thus bond yields vary directly with interest rates and bond prices vary inversely. You can see this clearly from the table. You can also see that market bond prices converge on the face value as the maturity date approaches.
Recent activity in bond markets
Investing in government bonds is regarded as very safe. Coupon payments are guaranteed, as is repayment of the face value on the maturity date. For this reason, many pension funds hold a lot of government bonds issued by financially trustworthy governments. But in recent months, bond prices in the secondary market have fallen substantially as interest rates have risen. For those holding existing bonds, this means that their value has fallen. For governments wishing to borrow by issuing new bonds, the cost has risen as they have to offer a higher coupon rate to attract buyers. This make it more expensive to finance government debt.
The chart shows the yield on 10-year government bonds. It is calculated using the ‘par value’ approach. This gives the coupon rate that would have to be paid for the market price of a bond to equal its face value. Clearly, as interest rates rise, a bond would have to pay a higher coupon rate for this to happen. (This, of course, is only hypothetical to give an estimate of market rates, as coupon rates are fixed at the time of a bond’s issue.)
Par values reflect both yield to maturity and also expectations of future interest rates. The higher people expect future interest rates to be, the higher must par values be to reflect this.
In the years following the financial crisis of 2007–8 and the subsequent recession, and again during the COVID pandemic, central banks cut interest rates and supported this by quantitative easing. This involved central banks buying existing bonds on the secondary market and paying for them with newly created (electronic) money. This drove up bond prices and drove down yields (as the chart shows). This helped support the policy of low interest rates. This was a boon to governments, which were able to borrow cheaply.
This has all changed. With quantitative tightening replacing quantitative easing, central banks have been engaging in asset sales, thereby driving down bond prices and driving up yields. Again, this can be seen in the chart. This has helped to support a policy of higher interest rates.
Problems of higher bond yields/lower bond prices
Although lower bond prices and higher yields have supported a tighter monetary policy, which has been used to fight inflation, this has created problems.
First, it has increased the cost of financing government debt. In 2007/8, UK public-sector net debt was £567bn (35.6% of GDP). The Office for Budget Responsibility forecasts that it will be £2702bn (103.1% of GDP in the current financial year – 2023/24). Not only, therefore, are coupon rates higher for new government borrowing, but the level of borrowing is now a much higher proportion of GDP. In 2020/21, central government debt interest payments were 1.2% of GDP; by 2022/23, they were 4.4% (excluding interest on gilts held in the Bank of England, under the Asset Purchase Facility (quantitative easing)).
In the USA, there have been similar increases in government debt and debt interest payments. Debt has increased from $9tn in 2007 to $33.6tn today. Again, with higher interest rates, debt interest as a percentage of GDP has risen: from 1.5% of GDP in 2021 to a forecast 2.5% in 2023 and 3% in 2024. What is more, 31 per cent of US government bonds will mature next year and will need refinancing – at higher coupon rates.
There is a similar picture in other developed countries. Clearly, higher interest payments leave less government revenue for other purposes, such as health and education.
Second, many pension funds, banks and other investment companies hold large quantities of bonds. As their price falls, so this reduces the value of these companies’ assets and makes it harder to finance new purchases, or payments or loans to customers. However, the fact that new bonds pay higher interest rates means that when existing bond holdings mature, the money can be reinvested at higher rates.
Third, bonds are often used by companies as collateral against which to borrow and invest in new capital. As bond prices fall, this can hamper companies’ ability to invest, which will lead to lower economic growth.
Fourth, higher bond yields divert demand away from equities (shares). With equity markets falling back or at best ceasing to rise, this erodes the value of savings in equities and may make it harder for firms to finance investment through new issues.
At the core of all these problems is inflation and budget deficits. Central banks have responded by raising interest rates. This drives up bond yields and drives down bond prices. But bond prices and yields depend not just on current interest rates, but also on expectations about future interest rates. Expectations currently are that budget deficits will be slow to fall as governments seek to support their economies post-COVID. Also expectations are that inflation, even though it is falling, is not falling as fast as originally expected – a problem that could be exacerbated if global tensions increase as a result of the ongoing war in Ukraine, the Israel/Gaza war and possible increased tensions with China concerning disputes in the China Sea and over Taiwan. Greater risks drive up bond yields as investors demand a higher interest premium.
Articles
Information and data
Questions
- Why do bond prices and bond yields vary inversely?
- How are bond yields and prices affected by expectations?
- Why are ‘current yield’ and ‘yield to maturity’ different?
- What is likely to happen to bond prices and yields in the coming months? Explain your reasoning.
- What constraints do bond markets place on fiscal policy?
- Would it be desirable for central banks to pause their policy of quantitative tightening?
In September 2023, the Stonegate Group, the largest pub company in the UK with around 4,500 premises, announced that it was going to start increasing the pint of beer by 20p during busy periods. There was an immediate backlash on social media with many customers calling on people to boycott Stonegate’s pubs such as the Slug & Lettuce and Yates.
This announcement is an example of dynamic pricing, where firms with market power adjust prices relatively quickly in response to changing market conditions: i.e. to changes in demand and supply.
Traditionally, prices set by firms in most retail markets have been less flexible. They may eventually adjust to changing market conditions, but this could take weeks or even months. If a product proves to be popular on a particular day or time, firms have typically left the price unchanged with the item selling out and customers facing empty shelves. If the product is unpopular, then the firm is left with unsold stock.
One business that makes extensive use of dynamic pricing is Amazon. Prices for popular items on Amazon Marketplace change every 10 minutes and can fluctuate by more than 20 per cent in just one hour.
Conditions for dynamic pricing to operate
The Amazon example helps to illustrate the conditions that must be in place for a firm to implement dynamic pricing successfully. These include:
- The capacity to collect and process large amounts of accurate real-time data on the demand for and supply of particular items i.e. the number of sales or the interest in the product.
- The ability to adjust prices in a timely manner in response to changing market conditions indicated by the data.
- Effectively communicating the potential advantages of the pricing strategy to consumers.
Consumer attitudes
The last point is an interesting one. As the Stonegate example illustrates, consumers tend to dislike dynamic pricing, especially when price rises reflect increases in demand. A previous article on this website discussed the unpopularity of dynamic pricing amongst fans in the ticket market for live musical events.
The precise reason for the increase in demand, can also have an impact on consumer attitudes. For example, following a mass shooting at a subway station in New York in April 2022, the authorities shut down the underground system. This led to a surge in demand for taxis and this was picked up by the algorithm/software used by Uber’s dynamic pricing system. Fares for Uber cars began to rise rapidly, and people started to post complaints on social media. Uber responded by disabling the dynamic pricing system and capping prices across the city. It also announced that it would refund customers who were charged higher prices after the subway system shut down.
There is a danger for businesses that if they fail to communicate the policy effectively, annoyed customers may respond by shopping elsewhere. However, if it is implemented successfully then it can help businesses to increase their revenue and may also have some advantages for consumers.
The growing popularity of dynamic pricing
It has been widely used in airline and hotel industries for many years. Robert Cross, who chairs a revenue management company predicts that ‘It will eventually be everywhere’.
More businesses in the UK appear to be using dynamic pricing. In a consumer confidence survey undertaken for Barclays in September 2023, 47 per cent of the respondents had noticed more examples of companies raising prices for goods/services in response to higher demand at peak times.
It has traditionally been more difficult for bricks-and-mortar retailers to implement dynamic pricing because of the costs of continually changing prices (so-called ‘menu costs’). However, this might change with the increasing use of electronic shelf labels.
It will be interesting to see if dynamic pricing becomes more widespread in the future or whether opposition from consumers limits its use.
Articles
Questions
- Explain the difference between surge and dynamic pricing.
- Using a diagram, explain how dynamic pricing can increase a firm’s revenue.
- Discuss both the advantages and disadvantages for consumers of firms using dynamic pricing.
- How might dynamic pricing influence consumer behaviour if it alters their expectations about future price changes.
- There is some evidence that the use of dynamic pricing is less unpopular amongst 18–24-year-olds than other age groups. Suggest some possible reasons why this might be the case.
- Using the concept of loss aversion, consider some different ways that a business could present a new dynamic pricing policy to its customers.
In a recent blog post on this site about the Microsoft/ Activision Blizzard merger, the European Commission had just reached a decision to approve the merger subject to remedies, but the investigations in the USA and UK were still ongoing. Since then, the merger has been approved by competition authorities around the world, including in the USA and UK, and thus the merger has gone through.
However, there were some differences in the way the case unfolded under the regulation of these three competition authorities.
The European Commission’s (EC) decision
The European Commission (EC) was the first to give the merger the green light. The EC’s in-depth investigation revealed concerns about the market for the distribution of games via cloud game streaming services. In particular, the concern was related to the possibility that Microsoft might make Activision’s games exclusive to its own cloud game streaming service (Game Pass Ultimate) and restrict access from competing cloud game streaming providers.
The EC argued that this in turn could strengthen Microsoft’s position in the market for PC operating systems, as Microsoft may have an incentive to limit or reduce the quality of the streaming of Activision’s games on PC’s which do not use the Windows operating system.
Thus, while the merger was approved, this was subject to remedies. These remedies included 10-year licensing commitments from Microsoft, as outlined in the EC’s press release:
These licenses will ensure that gamers that have purchased one or more Activision games on a PC or console store, or that have subscribed to a multi-game subscription service that includes Activision games, have the right to stream those games with any cloud game streaming service of their choice and play them on any device using any operating system.
This type of remedy is called a behavioural remedy and often requires the merging firms to commit to taking particular actions post-merger. Unlike structural remedies (which may for example, require the merging firms to sell off an entire business unit), behavioural remedies often require monitoring and enforcement by competition authorities. The EC argued that the deal, with these behavioural remedies, could strengthen competition in the market for cloud gaming.
The Federal Trade Commission’s (FTC) decision
The FTC, in the USA, had similar concerns to those of the EC related to the cloud gaming market. These were outlined in the FTC’s press release:
[The deal] would enable Microsoft to suppress competitors to its Xbox gaming consoles and its rapidly growing subscription content and cloud-gaming business.
The FTC also argued that when Microsoft had previously acquired gaming content, it had made this content exclusive to Microsoft consoles. This could result in higher prices, and reduced quality, choice and innovation. To this end, the FTC appealed in an attempt to block the deal, but the Court ruled in favour of the deal going ahead.
During this time, Microsoft announced that it had committed to keeping Call of Duty on Sony’s PlayStation after the merger, and this likely contributed towards the court’s decision. Hence, the FTC was unsuccessful in its attempt to halt the merger.
The Competition and Markets Authority’s (CMA) decision
The final hurdle remaining for Microsoft, was the CMA’s approval. As outlined in a previous blog post on this site, the CMA’s phase 2 investigation revealed similar concerns about the supply of cloud gaming services (amongst concerns related to the market for the supply of console gaming services, which were later dispelled), and whilst Microsoft offered some commitments similar to those accepted by the EC, the CMA did not deem these to be sufficient to address its concerns and thus prohibited the merger.
The CMA’s published remedies guidance suggests that the regulator has a preference for structural remedies over behavioural remedies. One of the reasons for this is because of the requirement to monitor and enforce the commitments, and this therefore formed part of the CMA’s reasons for not accepting the remedies. Unsurprisingly, Microsoft appealed this decision to the UK’s Competition Appeals Tribunal (CAT), probably partly driven by the fact that the EC accepted similar remedies to those rejected by the CMA. However, Microsoft and the CMA agreed that if the appeal was paused, Microsoft could propose a new deal.
The new deal: did the CMA make a U-turn?
In August 2023, Microsoft submitted a new restructured deal for the CMA to review. As described by the Chief Executive of the CMA, this deal was “substantially different from what was put on the table previously” and was therefore investigated as a separate merger case under the CMA’s phase 1 processes.
The new deal meant that Microsoft would no longer be purchasing the cloud streaming rights held by Activision. Instead, the cloud streaming rights would be sold to an independent third-party game publisher – Ubisoft. This means that Microsoft will not be in control of the cloud gaming rights for Activision’s gaming content (outside of the EEA), and therefore will not be able to restrict its competitors’ access to Activision’s games, which was one of the main concerns outlined by the CMA based on the initial merger proposal. The new deal also opens up the possibility that Activision’s games will be made available on cloud gaming services that run on a non-Windows operating system.
On 13 October, the CMA approved this deal, subject to the cloud gaming rights being sold to Ubisoft, and some subsequent commitments from Microsoft in relation to its relationship with Ubisoft post-merger, as outlined in the CMA’s final report. However, the Chief Executive of the CMA has emphasised that they are unhappy with the way that Microsoft dealt with negotiating the approval of the merger:
But businesses and their advisors should be in no doubt that the tactics employed by Microsoft are no way to engage with the CMA. Microsoft had the chance to restructure during our initial investigation but instead continued to insist on a package of measures that we told them simply wouldn’t work. Dragging out proceedings in this way only wastes time and money.
What’s next in big tech?
While the merger deal has now gone through, the FTC has recently re-opened its case against Microsoft, which will continue to unfold over the next couple of months until December when the case will appear in Court. This means it is possible that the FTC could attempt to undo the merger, though this would be challenging.
In the tech market more broadly, the CMA has recently launched a market investigation into cloud services. While the focus of this blog post was on cloud gaming, cloud services are now increasingly being used by many businesses. The CMA’s issues statement suggests that a key focus of its investigation will be on the ability for customers to switch between cloud service providers. Microsoft is one of the largest providers of cloud services in the UK, and therefore it is inevitable that it will be under scrutiny. Given all three regulators’ recent efforts to ‘crackdown’ on big tech, this is just one of a series of cases that will be interesting to see unfold.
Articles
Competition authorities documentation
Questions
- Discuss the effectiveness of behavioural remedies vs structural remedies for a merger.
- Why might the competition authorities have been concerned about the possibility of Microsoft making Activision’s games exclusive to its own cloud game streaming service? Is exclusive dealing always anti-competitive?
- Why was the transfer of the cloud game streaming rights to Ubisoft seen as a suitable remedy?
We have examined inflation in several blogs in recent months. With inflation at levels not seen for 40 years, this is hardly surprising. One question we’ve examined is whether the policy response has been correct. For example, in July, we asked whether the Bank of England had raised interest rates too much, too late. In judging policy, one useful distinction is between demand-pull inflation and cost-push inflation. Do they require the same policy response? Is raising interest rates to get inflation down to the target rate equally applicable to inflation caused by excessive demand and inflation caused by rising costs, where those rising costs are not caused by rising demand?
In terms of aggregate demand and supply, demand-pull inflation is shown by continuing rightward shifts in aggregate demand (AD); cost-push inflation is shown by continuing leftward/upward shifts in short-run aggregate supply (SRAS). This is illustrated in the following diagram, which shows a single shift in aggregate demand or short-run aggregate supply. For inflation to continue, rather than being a single rise in prices, the curves must continue to shift.
As you can see, the effects on real GDP (Y) are quite different. A rise in aggregate demand will tend to increase GDP (as long as capacity constraints allow). A rise in costs, and hence an upward shift in short-run aggregate supply, will lead to a fall in GDP as firms cut output in the face of rising costs and as consumers consume less as the cost of living rises.
The inflation experienced by the UK and other countries in recent months has been largely of the cost-push variety. Causes include: supply-chain bottlenecks as economies opened up after COVID-19; the war in Ukraine and its effects on oil and gas supplies and various grains; and avian flu and poor harvests from droughts and floods associated with global warming resulting in a fall in food supplies. These all led to a rise in prices. In the UK’s case, this was compounded by Brexit, which added to firms’ administrative costs and, according to the Bank of England, was estimated to cause a long-term fall in productivity of around 3 to 4 per cent.
The rise in costs had the effect of shifting short-run aggregate supply upwards to the left. As well as leading to a rise in prices and a cost-of-living squeeze, the rising costs dampened expenditure.
This was compounded by a tightening of fiscal policy as governments attempted to tackle public-sector deficits and debt, which had soared with the support measures during the pandemic. It was also compounded by rising interest rates as central banks attempted to bring inflation back to target.
Monetary policy response
Central banks are generally charged with keeping inflation in the medium term at a target rate set by the government or the central bank itself. For most developed countries, this is 2% (see table in the blog, Should central bank targets be changed?). So is raising interest rates the correct policy response to cost-push inflation?
One argument is that monetary policy is inappropriate in the face of supply shocks. The supply shocks themselves have the effect of dampening demand. Raising interest rates will compound this effect, resulting in lower growth or even a recession. If the supply shocks are temporary, such as supply-chain disruptions caused by lockdowns during the pandemic, then it might be better to ride out the problem and not raise interest rates or raise them by only a small amount. Already cost pressures are easing in some areas as supplies have risen.
If, however, the fall in aggregate supply is more persistent, such as from climate-related declines in harvests or the Ukraine war dragging on, or new disruptions to supply associated with the Israel–Gaza war, or, in the UK’s case, with Brexit, then real aggregate demand may need to be reduced in order to match the lower aggregate supply. Or, at the very least, the growth in aggregate demand may need to be slowed to match the slower growth in aggregate supply.
Huw Pill, the Chief Economist at the Bank of England, in a podcast from the Columbia Law School (see links below), argued that people should recognise that the rise in costs has made them poorer. If they respond to the rising costs by seeking higher wages, or in the case of businesses, by putting up prices, this will simply stoke inflation. In these circumstances, raising interest rates to cool aggregate demand may reduce people’s ability to gain higher wages or put up prices.
Another argument for raising interest rates in the face of cost-push inflation is when those cost increases are felt more than in other countries. The USA has suffered less from cost pressures than the UK. On the other hand, its growth rate is higher, suggesting that its inflation, albeit lower than in the UK, is more of the demand-pull variety. Despite its inflation rate being lower than in the UK, the problem of excess demand has led the Fed to adopt an aggressive interest rate policy. Its target rate is 5.25% to 5.50%, while the Bank of England’s is 5.25%. In order to prevent short-term capital outflows and a resulting depreciation in the pound, further stoking inflation, the Bank of England has been under pressure to mirror interest rate rises in the USA, the eurozone and elsewhere.
Articles
Blogs on this site
Information and data
Questions
- How may monetary policy affect inflationary expectations?
- If cost-push inflation makes people generally poorer, what role does the government have in making the distribution of a cut in real income a fair one?
- In the context of cost-push inflation, how might the authorities prevent a wage–price spiral?
- With reference to the second article above, explain the ‘monetary policy conundrum’ faced by the Bank of Japan.
- If central banks have a single policy instrument, namely changes in interest rates, how may conflicts arise when there is more than one macroeconomic objective?
- Is Russia’s rise in inflation the result of cost or demand pressures, or a mixture of the two (see articles above)?
