As a recovery begins to take hold, one of the biggest fears on Wall Street and across American business is that the Fed's huge injection of liquidity into the economy could lead to an insidious burst of inflation. How serious a danger is that? To get some answers, I talked with Charles Plosser, president of the Federal Reserve Bank of Philadelphia. Plosser is one of 11 Federal Reserve bank presidents who serve rotating one-year terms as members of the interest-rate-setting Federal Open Market Committee. This year he is not a voting member, but as a noted inflation hawk, he has been vocal about the need for vigilance.

MARIA BARTIROMOWhere are we in this economic cycle?

CHARLES I. PLOSSEREach month we get a little more good news. We still have some bad news to come, I suspect, but we're kind of bouncing around in that transition phase from contraction to recovery. I think in the coming months we'll see increasingly good news. I hope we'll see some positive growth in the second half.

You said back in July we will probably have to begin raising rates sometime in the not-too-distant future. It's now September. What is the not too distant future?

Your guess is as good as mine. It clearly depends upon the path of the recovery. But we may have to [raise rates] at a time where unemployment rates still seem pretty high, because monetary policy works with a lag. We may potentially face a situation where we have to be as aggressive raising rates as we were in cutting them.

So how concerned are you that we will err too much on the side of easy money and set off a fireball of inflation that will be difficult to contain?

That's the big challenge. We will need some political fortitude, so to speak, to maybe make some tough choices at the right time.

If you were a voting member of the Federal Open Market Committee this year, how would you have voted in the last two sessions?

I guess I would have been with the majority. I wouldn't have raised rates yet.

What signs of impending inflation do you watch most closely?

Clearly, expectation is a very important element of our concern about inflation—what the public and businesses think about inflation. Commodity prices and other things are relevant, but they can often mask inflation trends. A massive amount of liquidity has been added to the banking system, and if that liquidity were to begin being translated into loans and growth and liquidity in the economy more broadly, we would create an inflation problem.

Is it fair to say that Topic One on the Fed's agenda is an exit strategy?

Well, I don't know if it's Topic One, but it certainly is high on our agenda. We've spent a great deal of time talking about that, worrying about it, making sure we have the adequate tools to do what we think will be necessary at the appropriate time, and debating what the appropriate time may be.

What is the exit strategy?

The exit strategy will involve two pieces. One, there will be a time when we will have to raise interest rates. That will help us drain reserves from the banking system. And at some point we will have to shrink the Fed's balance sheet. Raising interest rates will help us do that. And shrinking the assets on our balance sheet may involve selling assets or slowing down our purchases.

Do you expect more banks to fail?

Oh, I'm sure more banks will fail. That shakeout is probably not over.

You saw [FDIC Chairman] Sheila Bair's op-ed in The New York Times on Sept. 1 saying that we shouldn't have one single regulator of banks. Do you agree with that?

That's a moot question, because I think we'll continue to have multiple regulators for a while.

What is the most dangerous threat to the economy and the recovery?

That's really hard to say. I think what's most dangerous is the thing we don't know—another shock that could derail the recovery or the financial system.

How do you respond to critics who say the Fed now has too much power?

One of the most important things that the Fed does is monetary policy—ensuring price stability and using price stability to ensure that we have sustainable intermediate and longer-term growth. We need to be very careful we don't have powers or authority or responsibilities that impinge on our ability to conduct sound monetary policy with the independence that requires.

Do you worry that with tax cuts expiring we won't see substantial incentives for business investment and the creation of new jobs? And do you think these higher taxes could slow down the recovery just when it's getting started?

Certainly higher taxes, depending on which taxes they are, can be a disincentive to growth. There's no question. But having said that, the bigger longer-term issue is that we need to get back to a more sustainable path for fiscal policy. It is not sustainable in its current projections by the CBO [Congressional Budget Office], and I think we have some major challenges in front of us.

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