The UK authorities are in danger of getting themselves in a mess over when the first rate rise should be. The Governor of the Bank of England somewhat rashly suggested that this could be when unemployment falls below 7%. Now that employment is at 7.1%, one could reach the conclusion that a rate rise is imminent. Not so says the Governor; 7% was only an indicator and the rate rise is still a long way off. The result is that everyone is confused and really none the wiser, which was not the intention of the Bank of England. What should determine when the first rate rise occurs? Unemployment is certainly one possible indicator and the level has fallen from a peak of 8.4% just over a year ago to 7.1% now. But the employment market has been behaving somewhat strangely recently with a large fall in productivity as employers have squeezed wages rather than employment. This rather suggests that rising output could easily be produced by the existing labour force without introducing any stress into the system. The second indicator is inflation and here the evidence is that inflation is falling rather than rising. Indeed, many commentators are worried about the threat of deflation, and are urging the authorities to maintain an easy money policy for much longer. Neither employment nor inflation supports the case for a rate rise. There is a third indicator that possibly does and this is nominal GDP. This is not quite the same as targeting nominal GDP which some commentators support but it is along the same lines. Before the financial crisis, UK nominal GDP grew at an average rate of around 5% (2.5% real growth and 2.5% inflation very roughly). UK nominal GDP is currently growing at 3%pa and accelerating. Whether or not it goes through 5% is anyone’s guess and it may be that the current recovery will fizzle out particularly if the BoE increase rates prematurely. The possibility of derailing a nascent recovery is a very real risk and one that the Japanese were quite good at doing in the 90s and 00s. Low and falling inflation is probably telling us that there is plenty of spare capacity, albeit the rapidly falling unemployment rate is suggesting something rather different. The BoE does not have an easy task and no-one will blame it for doing nothing at the moment. Wait and see is the correct policy response. But the indicator to watch is nominal GDP, particularly after the very strong preliminary 4/Q GDP estimate. Do not be distracted by over emphasis on the inflation rate. By way of contrast is the situation in Europe, where there is a very real risk of deflation and emphasis on the core inflation rate is very much justified. The latest reported core inflation figure is 0.7% and falling. Nominal GDP growth is minimal. There is evidence of quite a strong bounce in activity but from a very low base. There is very little evidence that Europe will catch up what it has lost in relative terms over the last two years. The exchange rate is too high and the ECB needs to be much more active in stimulating activity. It remains too complacent.