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Zoltan Pozsar On Why the Fed Needs to Spark a Market Crash to Bring Down Inflation

Fed versus stonks?

Fed versus stonks?

Photographer: Aaron McKenzie Fraser/Bloomberg

Three themes have emerged in some recent Odd Lots discussions.

The first is the Federal Reserve’s struggle to tighten financial conditions even as it prepares to raise interest rates. While mortgage rates have moved up recently, overall financial conditions remain roughly where they were in the summer of 2020, just after the central bank flooded the system with emergency liquidity.

Another theme has been the idea of a wealth effect from booming stocks, houses prices and potentially crypto. And while wealth effects are something every economist thinks about, the degree to which higher asset prices might be fanning inflation is perhaps still unappreciated. Joseph Wang, a.k.a "Fed Guy,” called the latter a potentially “enormous wealth boom that you don't see,” and one that might even be contributing to current tightness in the labor market. 

The third theme is the idea that the Fed may have to induce a recession in order to bring down inflation. After all, it can’t do much to boost supply. It can only bring down inflation by curbing demand, in which case it will need to slow growth in order to ease pricing pressures. That’s something which has been brought up by Citigroup Inc. Strategist Matt King as well as the SGH Macro’s Tim Duy.

Only one man can marry these three themes together, of course, and that is Credit Suisse Group AG Strategist and repeated Odd Lots guest Zoltan Pozsar.

In a note published late on Wednesday, Pozsar argues that in order to tame inflation, the Fed needs to mount a Paul Volcker-style shock strategy aimed at popping valuations in risk assets that range from stocks to credit and even crypto. And while that’s a pretty controversial idea on Wall Street, Pozsar’s argument is that tightening financial conditions in this manner would allow the Fed to slow services inflation (including owner’s equivalent rent, or OER) without completely derailing growth.

The idea here is that given that if the Fed needs to balance two slightly altered mandates — stable prices and inclusive employment — it might make more sense to do that by bringing down asset prices rather than tank the entire economy in a way that will hit low-income households hardest: