The U.S. economy is recovering "pretty well" and trying to juice it up by allowing a little extra inflation would be disastrous, said Paul Volcker, the former Federal Reserve chairman known for successfully reining in double-digit inflation.
"I think that is kind of a doomsday scenario," Volcker told an economic summit when asked if the Fed should foster higher inflation to stimulate faster growth.
Higher inflation would backfire by causing interest rates to rise. "You are not going to get any stimulus and you are going to make it much harder to restore price stability," Volcker told the Atlantic magazine conference.
"We have an economy that needs support. We are doing that with extreme fiscal policy. We are doing that with extreme monetary policy," Volcker said.
Once the economy is on a sounder footing, he expressed confidence that the Fed will face no difficulty in shrinking its balance sheet without causing disruptions. "They do not in my judgment present a technical problem," he said.
More difficult will be for the Fed to decide when is the correct time to start tightening policy and raising rates — something that is not a new problem for monetary policymakers. "They are likely not to be widely welcomed in the political environment. But that is what central banks have to do," Volcker said.
While there are no quick fixes for a severely damaged economy, the former Fed chairman said progress is being made.
"All things considered, I think we are doing pretty well," Volcker said. "Unemployment is coming down, but we can't ask for more than the economy can produce in the short run because we haven't eliminated the overhang of housing, and the enormous debt is still there."
The biggest challenge now facing politicians and policymakers is to return the United States onto a sustainable fiscal trajectory, he said.
Former U.S. Treasury Secretary Robert Rubin shared that view, warning that failure to agree upon a deficit reduction plan after the November elections would risk serious market upheaval, in which debt yields would rise and the currency plunge.
"Markets can change dramatically, and it is almost instantaneously with no notice, which is why it is imperative we act," Rubin said.
At the same time, he counseled a careful approach to deficit reduction. Recent economic numbers have been "good", Rubin said, but the U.S. economy still faces significant headwinds — from the euro zone crisis and the U.S. fiscal challenges.
Allowing tax cuts to expire at the end of 2012 and proceeding with deep federal spending cuts would cut 4 percent to 5 percent from GDP growth, which would have "enormous, enormous consequences for the economy," he said.