The Fed doesn't have to go 'full Volcker' on inflation and any pivot on its rate hike policy could end the stock market's downward spiral, Fundstrat says

• The Fed doesn't need to go "full Volcker" on raising interest rates to combat inflation, according to Fundstrat's Tom Lee.
• Leading indicators suggest financial conditions are tightening and inflation is coming down, Lee said.
• "Compared to 1970s-1980s, today's inflation is nascent," Lee said, adding that inflation in 2022 is "hardly out of control."

Federal Reserve Chairman Jerome Powell is taking a page out of former Fed Chair Paul Volcker's playbook in his attempt to tame inflation via aggressive interest rate hikes, and it's driven the stock market into a death spiral.

But according to Fundstrat's Tom Lee, Powell runs the steep risk of over tightening at a time when leading indicators show a continued tightening in financial conditions and a likely peak in inflation.

Rent prices have seen their biggest September drop in six years according to the Apartment List National Rent Index, home prices have seen their biggest price deceleration on record according to the Case-Shiller Index, and new job openings are beginning to fall, the note said.

On top of that, there's a big difference between the inflation that Volcker was fighting in the early 1980's relative to today's ongoing surge in prices.

"An important perspective to keep in mind is Fed Chair Volcker accepted his role as Fed Chairman in 1979, a time when the US was already 12 years into high inflation," Lee said, explaining that inflation broke above 2% in 1967 and cumulative inflation by 1979 saw a compounded annual growth rate of more than 5%.

"Volcker needed to unwind 15 years of inflation," Lee said, which means his aggressive interest rate hikes were appropriate at the time.

But today, inflation is "young" with prices only 7% above a 2% trend since 2019. "Compared to 1970s-1980s, today's inflation is nascent," Lee said, adding that inflation in 2022 is "hardly out of control."

That means Powell has a lot less wood to chop when it comes to taming inflation, and he "doesn't have to go full Volcker," according to Lee. "While the commitment to quash inflation makes sense, the battle against inflation is much younger."

And inflation could still fall even if the Fed decided to cut interest rates due to too tight financial conditions, Lee said, pointing to early 1990 as an example. At that time, inflation surged due to a spike in energy prices related to the Gulf-war.

But CPI ultimately fell from 6.3% to 2.6% in two years, even as the Fed was cutting interest rates.

That means any pivot in inflation, or the Fed's interest rate hike trajectory, or both, could lead to a big recovery in the stock market.

"Markets are approaching levels where any rebound will be steep. As noted earlier, we think investors are overly skeptical on the economy's ability to overcome inflation. While there remain upside risks and surprises, there are also signs of progress," Lee concluded.