WASHINGTON (MarketWatch) — Perhaps it takes someone who has seen it all to point out when times have changed.

Alice Rivlin has been a top economic policymaker in Washington since 1975 — she was the founding director of the Congressional Budget Office, a key player in the Clinton White House and the number-two official at the Federal Reserve.

Destructive inflation is an “oh-so-last-century threat” that should be moved down our list of macroeconomic concerns to make room for others, Rivlin said a speech last month when she received the Paul A. Volcker Lifetime Achievement Award for Economic Policy from the National Association for Business Economics.

The central bank’s top job is now fighting financial instability, Rivlin said. “It is a different punch bowl at a different party than it used to be— now related to systemic risk-taking rather than runaway inflation,” Rivlin said.

Ahead of the upcoming Federal Open Market Committee meeting, MarketWatch was able to catch up with Rivlin and get her views on the economy, Fed policy, and her worry about new challenges to the central bank’s independence. The interview was lightly edited for clarity.

MarketWatch: Let’s start with your views on inflation and the economy.

Rivlin: I don’t think inflation is a threat for the foreseeable future. We used to think of inflation as the major thing that central banks had to guard against, but that was back when our economy was much more inflation-prone than I perceive it to be right now. Inflation happens when you have a roaring boom — wages are rising, labor markets are tight — and wages and prices get into a spiral. We’re not in that situation right now at all. We have a slow-growth economy, slow growth in wages, considerable slack in the labor market. unemployment rates have come down but we still have very low labor force participation, and that is partly because our population is aging, but it isn’t all because of that. Rates for prime-age men are unusually low— we don’t know exactly why that is, but it indicates that there is slack in the labor market.

So I don’t see inflation as something we need to worry about right now. And even if it happened, even if we had some kind of shock that sent prices up for some reason, the Fed has the tools to stop inflation. That’s not very hard. And we’re unlikely to get into a self-perpetuating spiral because the economy is much more competitive than it used to be and because we haven’t had inflation for such a long time. There is a whole generation of people who don’t remember inflation. They don’t know what it is. And so I think inflation is a non-existent threat.

MarketWatch: But, even with inflation so low, 15 out of 17 Fed policy makers want to raise rates this year. What is going on?

Rivlin: I think there is a perception at the Fed, and probably pretty much shared by everybody, that it would be nice to get back to normal. And normal means that you have an interest rate which you can both raise and lower. And the Fed is not in that situation right now. They are very close to zero. And so it would more comfortable to be at a higher interest rate. On the other hand, raising interest rates in the face of a slow-growth economy with no inflation is a little bit hard to justify. So I don’t know what they are going to do.

MarketWatch: Seems like two camps among private-sector economists, some who think the economy can get past the headwinds of recession and get to normal and others who are worried about more fundamental factors. So you’re in the worried camp?

Rivlin: I am in the camp that is worried that our economy is not growing robustly and that anything like raising interest rates might slow it further.

MarketWatch: Do you think a rate hike could trigger instability in markets?

Rivlin: The markets are expecting an interest rate increase at some point this year so, no, I don’t think a modest increase is going to be destabilizing. But, if you start moving interest rates up, there will be an expectation that it will go further. And I think that must be what the FOMC is most worried about. They don’t want to create an expectation that they are on a track to raising interest rates one meeting after another when that may not be appropriate. So they will do everything, if they do raise, to say “we haven’t decided what we are going to do next.”

MarketWatch: Do you think rates could go negative?

Rivlin: Certainly real rates can go negative and often have. That is one reason for wanting inflation to be a little higher, so that, if necessary, real rates can go below zero. Can nominal rates go below zero? In principle, yes, and in fact there is some experimenting with this in Europe, but it seems to me it is something that is a little bit counter intuitive.

MarketWatch: If inflation isn’t the most urgent issue facing the Fed, what is?

Rivlin: I think the most important question for the Fed to be focusing on is financial instability over the next few years.

MarketWatch: What’s the basis for this concern?

Rivlin: I think the financial crisis and the worldwide recession that followed it was such an economic disaster that we want to make sure it doesn’t happen again. And I worry sometimes that people say: “Oh, we’re back to normal, the stock market is back to normal, financial institutions are profitable again, the unemployment rate has come down, it is all over.” But I think it is not, in the sense that the cost of 2008 was enormous, it was paid by small people all around the world who can never recoup, and we just don’t want to let it happen again.

MarketWatch: There does seem to be a backlash in Congress underway, with many arguing regulation went too far.

Rivlin: There is some worry that regulation went too far. Regulation does swing back and forth and maybe we’re always fighting the last war, but after the lax regulation of 2005-6-7 failed to prevent this catastrophe, the idea that we shouldn’t have tighter regulation is ridiculous.

MarketWatch: And this has gotten tied into threats to the Fed’s independence.

Rivlin: I think we do have to worry about the independence of the Fed because the necessary greater emphasis on financial stability means the financial community is going to be more suspicious of the Fed, more pushing back on regulation. That combines with the idea that somehow interest rates ought to be higher, which I find a little hard to fathom, but it is quite pervasive.

MarketWatch: So when we speak of taking away the punch bowl, in this new century that means being tough regulators?

Rivlin: If we get into a serious asset-price bubble, then I think we know that monetary policy is not a good tool. Direct regulation will be necessary, meaning things like leveraged ratios and capital ratios and counter-cyclical changes, and those will be resisted.