Former Federal Reserve Chairman Ben Bernanke is optimistic the U.S. economy can power through renewed global economic weakness and inflation will pick up, but said Congress has to be the first line of defense just in case the downward pressure is too much.

On the eve of the likely first interest rate hike in nine years, Bernanke told MarketWatch the domestic economy is “pretty strong,” resilient enough to withstand the headwinds from the weak global economy.

Relaxing in his office at Brookings Institution with a bird’s-eye view of the Dupont Circle neighborhood, Bernanke spoke to MarketWatch about the outlook for monetary policy and long-term issues facing the economy.

And while the Fed is on the brink of moving off zero, Bernanke acknowledges it may have to return to that level. “In a world with low inflation and low nominal interest rates, there is potentially less room to maneuver,” he said.

Here is a transcript of the interview, lightly edited for clarity.

MarketWatch: It looks like we’re approaching the end of an era of zero rates this week. What are your thoughts?

Bernanke: I want to be careful about not second-guessing Janet Yellen. Nobody would like the person who formerly had their job publicly commenting on their decisions. But evidently the market thinks the Fed will, this week, raise the federal funds rate. It would be a landmark decision given that rates have been at zero since 2008, which was longer than we anticipated. The good news is that the U.S. economy has made a lot of progress, unemployment is down to 5%, we’ve had moderate growth, the domestic economy, particularly, is pretty strong. Most of the headwinds right now are coming globally, so it is a landmark event certainly.

MarketWatch: You never imagined zero rates would last so long.

Bernanke: No we didn’t. We were over-optimistic about the pace of growth in large part because we didn’t anticipate the slowdown in productivity growth that we’ve seen. However, from a cyclical perspective, the economy has recovered in fact more quickly than we anticipated in that the unemployment rate has fallen more quickly than we thought it would, indicating that we have moved back towards something approaching full employment. Over the last three years, the unemployment rate has fallen about 3 percentage points which is relatively rapid, so, in that respect, the economy has actually done a little better than we have anticipated but in terms of overall growth it’s been less good.

MarketWatch: What’s your outlook for the economy?

Bernanke: Well, the key issue is whether the domestic strength — which we see in household spending, in auto sales, in housing — whether that domestic strength is sufficient to overcome the headwinds from the global economy. And I tend to be optimistic but it is clearly something we’re going to have to pay close attention to going forward.

MarketWatch: How fast will rates rise and how far up will they go?

Bernanke: Certainly there has been a long-term downward trend in longer-term interest rates and every indication is that the equilibrium interest rate —the rate that ultimately will be consistent with stable growth — is lower than it has been in the past. So that’s clear. I expect the Fed will be very cautious and gradual, that’s what they’ve told us many times, and they’ll be looking for evidence that the economy has been able to accommodate the higher rate increases and still continue to grow.

MarketWatch: In your forecast, you didn’t talk about inflation. Do you see inflation going back to 2%?

Bernanke: Our basic models of inflation suggest it ought to, as slack declines and as the labor market tightens, we ought to see upward pressure on prices. Also as the effects of the dollar strengthening over the last year-and-a-half and the big decline in oil prices, those things work their way through the system, those sources of disinflation will ultimately wash out. So I would expect inflation to rise but it’s also true that we haven’t seen as much inflation as most economists expected. Clearly the global environment, which is one of still considerable slack resources, very weak commodity prices, strong dollar, those elements are still holding back inflation.

MarketWatch: Ever since you started bond purchases, there has been criticism that the Fed was manipulating rates and there would be hell to pay one day. That concerns continues. Martin Feldstein recently said that QE was propping up stock prices and they were bound to fall. How do you respond?

Bernanke: So first, the idea that somehow the Fed is somehow artificially manipulating interest rates is not very logical. What the Fed is trying to do is to get market interest rates to a level consistent with sustainable growth. And given the large amount of slack we saw in the last few years, given the fact that fiscal policy was, if anything, somewhat restrictive, the interest rates needed to get the economy growing again were quite low or negative. So the Fed was basically only trying to get interest rates toward or to the level that were consistent with a healthier economy. So, I wouldn’t call that artificial interest rates. I would call that an attempt to move rates in the direction of where the economy really wanted them to be, in some sense.

“ ’[T]he idea that somehow the Fed is somehow artificially manipulating interest rates is not very logical. What the Fed is trying to do is to get market interest rates to a level consistent with sustainable growth.’ ” — Ben Bernanke

So, in that respect, the Fed is doing what monetary policy is supposed to do, which is to try to set market rates somewhere close to the rate that supports the dual mandate of maximum employment and price stability. There is some evidence of success there in that we’ve seen unemployment fall to 5% and inflation, while still too low, is moving towards target and we have not seen deflation or high inflation. We’ve seen something in fact closer to a more moderate level of inflation. In terms of the purported bad side effects of QE, critics will say it is not over until it’s over, but we can certainly say that to this point, concerns that critics have voiced including high inflation, commodity price spikes, collapse of the dollar, stock market bubbles, failure to recover, all those things that have been repeated over and over again, by a whole litany of critics, but not by professional economists for the most part, so far have failed to manifest. And if you look at the U.S. economy, both in terms of growth and inflation, we are considerably closer to target than any other major industrial economy and so the results thus far, given where we started, have been reasonably good.

MarketWatch: Why not hold rates at zero and shrink the balance sheet first?

Bernanke: The reason for doing it in this sequence is simply a matter of familiarity and predictability. The Fed has always used short-term interest rates to tighten or ease policy and in this environment where there is a lot of uncertainty, the Fed believes that the effects on financial markets of raising short-term interest rates are more predictable, the effects on the economy are more predictable than selling assets. So in the spirit of trying to get the economy well into the normalization process before beginning to reduce asset holdings, I think the widespread agreement on the Fed is that it is better to start with short-term interest rate changes and leave the unwinding of the Fed’s balance sheet until later.

MarketWatch: Will that be another hurdle for markets?

Bernanke: That will be another hurdle. But the Fed has told us that they expect to do it in a very passive and predictable way so it shouldn’t generate a huge amount of volatility or uncertainty among financial market participants once the process begins.

MarketWatch: Do you support the idea that the Fed should keep a larger balance sheet than it did pre-crisis?

Bernanke: I think it is an open question. Many other central banks function, in normal conditions, with much larger balance sheets relative to GDP than the Fed has traditionally used and there are arguments in favor of a large balance sheet including the possibility that the central bank can provide short-term liquid assets to the market in a time when those assets are in short supply. The FOMC apparently feels that it is better not to have such a large presence in the market. They also have expressed concerns about the existence of the reverse-repo program — which needs to be tied to the balance sheet — they have expressed concern this reverse-repo program might lead to financial instability if holders of short-term money move their funds from financial institutions say to the Fed, so for those reasons, the FOMC has decided they want to go back to a balance sheet that was more consistent with the pre-crisis normal. I don’t oppose that. I just think there are arguments on both sides.

MarketWatch: Financial markets seemed rocky over the past week, a lot of big moves ahead of the Fed meeting.

Bernanke: Depends how you define big. A 3% or 4% movement in the stock market compared with what we saw a few years ago is really pretty minor.

MarketWatch: And the price of oil is dropping.

Bernanke: Oil dropping, for example, is probably an indication of developments in the global economy, and as I said, the weakness in the global economy is an important consideration for the Fed, so that is something they are going to have to pay attention to. I can’t imagine, though, at this point, speaking now before any action is taken, I can’t imagine that markets would be surprised if the Fed acts on Wednesday. Surely by now they have taken under advisement the likelihood of Fed action this week.

MarketWatch: But would global concern might force the Fed pause on Wednesday?

Bernanke: Well, so, there are two issues. One is the effects of the global economy on the United States, which is the primary concern for the Fed, because the Fed’s mandate is to achieve domestic objectives, namely maximum employment and price stability. And it is the judgment of the FOMC that the domestic strength of the U.S. economy will overcome those headwinds from the global economy. A related issue, however, is the risk that between Fed tightening, stronger dollar, weaker China, and various other international developments, that there will be financial stress in emerging markets. And that is certainly something that the Fed and other international agencies have paid close attention to. If that were to happen and it were severe it could feedback on the U.S. economy and would be a concern for the Fed, but the Fed’s interest-rate decisions are, in the first instance at least, motivated primarily by the outlook for the U.S. economy.

MarketWatch: Larry Summers wrote recently that short rates would have to get up to 3% in order to give the Fed ammunition to combat another recession and he thought that was unlikely to happen. So there is a risk that we’ll return to zero rates?

Bernanke: Yeah, in a world with low inflation and low nominal interest rates, there is potentially less room to maneuver, if, in fact, the highest the nominal interest rate ever gets is the 3%-to-3.5% range that the FOMC projects. If there is another recession, then the Fed will have less scope to cut rates obviously and that is a potential concern. There are a couple of backstops. One is that the Fed could once again undertake non-standard policies including for example negative interest rates or potentially quantitative easing should it come to that. The other possibility, I would hope, if we get to that position, that fiscal policy would be more constructive. That would be the right solution from the economy’s point of view to have more fiscal support, in a time when the central bank’s ability to stimulate is more limited.

MarketWatch: You mentioned negative rates. We’ve written about this and there seems to be a real visceral dislike for the idea. Should regular people worry about it? In some ways, the world turns upside down with negative rates.

Bernanke: There is nothing special about zero from an economists perspective where you have to distinguish between nominal and real interest rates. Real interest rates are equal to the nominal rate minus the inflation rate. I think negative nominal interest rates are something the Fed might consider. We’ve seen it put to work in Europe primarily. But the scope for negative nominal interest rates is fairly limited. You can’t get very negative before people will begin to hoard cash, for example, which pays zero nominal interest rates. Although I’ve been surprised by how negative have been able to get in some European countries, I don’t think that, in the context of the United States, I don’t think that it could really be a central tool because I don’t think that rates can get that negative.

In Europe, I don’t think most ordinary people have been affected very much by negative rates. I am not aware that ordinary checking accounts are paying negative rates. In the U.S., while I think negative rates are something the Fed will and probably should consider if the situation arises, I think there are limits to how negative rates could go and there are probably special features of the institutional environment in the United States which suggests they couldn’t go as negative here as they’ve gone in some European countries. So I don’t think it should be something of creating a lot of anxiety for ordinary people at this point.

MarketWatch: Adair Turner [former head of the U.K.’s Financial Policy Committee] talks in his new book about a central bank funding a tax cut — that we should think about that as a way to combat a downturn. What do you think of his idea?

Bernanke: What that boils down to is coordination of monetary and fiscal policy. If the Congress decides to do a tax cut and the central bank does asset purchases equal to that amount, it is really a coordination of monetary and fiscal policy. There are circumstances where that should be considered, where, for example, if you are in a deflationary situation or approaching a deflationary situation. I don’t think it is something that we need to be thinking about in the United States right now, but just in general, having fiscal policy become a bigger part of our recession-fighting toolkit would be desirable. I understand that there are political barriers to that, but not withstanding the political views of the Fed, if the next administration finds itself at risk of recession, and the Fed tells the president that they are sort of running out of weapons from the point of view of the economy, then fiscal authorities ought to give some thought to how they want to respond. So, it is nothing to do with the Fed per se, it has to do with whether or not Congress wants to take the necessary action to help restore growth in a hypothetical future situation where the economy is slowing and the Fed has exhausted its firepower.

MarketWatch: All this seems unlikely given in general the sour view of the Fed generally held by Republicans. Do you that will abate?

Bernanke: I don’t know. There is a lot of populism in the country. There is a lot of anger about economic developments in general, and the Fed is one object of that anger. I hope things will get better over time. I think, as the economy improves and as some of the extreme predictions of Fed critics don’t come true — hyperinflation and the like — that the anger will diminish. But the political environment certainly is not very good. I’d agree with that.

MarketWatch: With growth and interest rates low, won’t it be harder to pay for our entitlement programs?

Bernanke: It is generally true that, in the longer term, we face important fiscal challenges, and some of those are related to, particularly, the cost of health care. There are a couple of countervailing factors. One is that, in general, when inflation is low, the costs of the programs also grow more slowly, for example, Social Security is indexed to inflation, but also we’ve seen in the last few years that health-care inflation has been pretty moderate. Now, if that continues, that would be really good news for the long-term fiscal situation. If health care costs begin to grow again at the rate they were growing a few years ago than that will ultimately challenge the ability of the fiscal authorities to meet their stated obligations. But these things are not immediate. The Congressional Budget Office doesn’t believe these will be serious problems for the deficit for a number of years yet, and so, in the very short-term, if there was a need for fiscal expansion, there really wouldn’t be any reason not to do it from an economic point of view. In fact, I made the same argument frequently, as chairman, during the period of recovery, which was that I felt that fiscal authorities were too focused on short-term cuts, whereas the deficit problems were mostly long-term and that the right approach would be to tailor the short-term budget position to the business cycle while at the same time making decisions about the long-term balance that would create confidence that our fiscal situation would be stable in the long run.

MarketWatch: In your book “The Courage To Act,” doesn’t your policy prescription — tax reform, sensible immigration reform, infrastructure spending — make you sound like a Democrat?

Bernanke: Basic economics tells you that growth depends on capital, labor, and technology – those are the basic inputs to sound growth. Capital, you have both public and private capital, so you want to have good tax policy, for example, to encourage private capital investment. You want to have appropriate public capital investment to develop the infrastructure to make sure the economy can grow. On labor, you want to have more skill acquisition, better training and sensible immigration policy is part of the process of keeping our workforce healthy and growing. And then, I would say, on the technology side, that support for basic research and other efforts to maintain our technological leadership are really important for growth. So I think these are pretty much standard economist viewpoints. I think that economists across the spectrum would support most of those things.

MarketWatch: You talked about income inequality being an important challenge to the economy. What are the solutions?

Bernanke: There is no simple solution. If there were a simple solution presumably we would have done it by now. Income inequality in the U.S. has been rising for at least 35 years, so, it is not something that can be solved by a bumper sticker. I mean, it requires sustained efforts on a variety of fronts. Exactly how that should proceed is the subject of a lot of debate among economists. Probably the best approach would be one that addresses lots of different dimensions of the problem.

Clearly one aspect is making sure that Americans have as much opportunity as possible and that means improving levels of skills and education, training, those are important and, in general, trying to achieve more economic growth with some of the other methods I was talking about. A very controversial approach is through tax-and-transfer policy, [and] there is a whole set of issues there in terms of both efficiency and equity that economists have been debating for some time. But clearly that is also a direction that policy makers could go. But it is a complicated problem. It has been ongoing for a long time. I am very skeptical that the Fed or any recent developments are particularly important for this. I think it is again a long-term trend, a long-term issue, and the best way to tackle it is along a wide variety of fronts.

MarketWatch: If the economy can’t grow much more than 2%, aren’t there more risks that it can get pushed into a ditch by unexpected shocks.

Bernanke: Yes, that’s a bit of a concern. I think there is some sense the economy has a level of growth below which there is greater risk of downturn. You see it in Japan for example which has a very slow ordinary potential rate of growth and has greater difficulty maintaining forward momentum perhaps because of that. In a world in which the underlying pace of growth is slow and interest rates are low under normal conditions, then there probably is somewhat greater risk of a downturn and less scope for monetary authorities to respond to that, which is, once again, why fiscal policy needs to be part of the mix in the short term. But also, growth is not a given. Good economic policies can promote growth over the medium term and I hope whoever is leading the government in the future will try to find the right tools to increase the growth rate.