Wharton professor Jeremy Siegel warns the Fed is 'playing with fire' in its handling of the economy as liquidity falls dramatically, but he's still a buyer of stocks over bonds

• The Federal Reserve is "playing with fire" in its handling of the economy if it hikes rates by 75 basis points, according to Jeremy Siegel.
• Despite the ongoing risks from the Fed's aggressive interest rate hike policy, he still likes stocks over bonds.
• "You're going to get a bigger bang for your buck in the stock market," Siegel said on Thursday.

Wharton professor Jeremy Siegel is growing increasingly concerned about the Federal Reserve's handling of the economy as it continues to move ahead with its hawkish rate hike and balance sheet reduction policies.

"This is, to me, playing with fire in terms of what could happen to the economy," he told CNBC in a Thursday interview.

Siegel's concern stems from fast-declining money supply and its impact on liquidity in markets around the world, combined with overly aggressive interest rate hikes that are based on the Fed's outsized focus on lagging inflation indicators.

Markets are now pricing in the likelihood of the fed funds rate reaching 5% by May of next year.

That level "is way too high in this world with inflation coming down. Don't quote year-over-year. Look forward on the real prices," Siegel said. "I think you're really getting 2% [or] 3% forward-looking real inflation. Going up [to] 5% in today's world, it's too tight."

Instead of hiking interest rates by another 75 basis points at its upcoming November and December FOMC meetings, as the market now fully expects, the Fed would be better served by raising interest rates just 50 basis points in November and then pausing, according to Siegel.

"I can understand another 50 basis points, but then wait," he said. And if the Fed does that, the economy could end up looking a lot better in the coming months than some expect.

"If they can stop now or just [do] a small increase and then wait and look around, I think we have a chance at avoiding a recession," Siegel argued.

Much of the argument being made by Siegel is driven by the fact that on-the-ground inflationary data is showing a deceleration from recent highs, while the data focused on by the Fed is considerably lagged.

"They [Fed officials] think service inflation keeps on going up, but it's because of the way the Bureau of Labor Statistics computes that housing data. It distorts it on the upside right now, just like they distorted it on the downside," he said.

Regardless of what the Fed does in November, investor attention has turned to the third-quarter earnings season, and results are faring better than most expected. Siegel is not surprised, because companies were able to take advantage of years of low interest rates, as well as today's inflationary environment.

"Right now, [companies] are kind of in the sweet spot in terms of locking in low debt, being able to raise prices, leveraging the gains on the wage front," he said, adding that most company debt is locked in for many years at 2% or 3% interest rates.

And that sets stocks up for upside in the long-term, according to Siegel, who still prefers the asset class over bonds despite the recent surge in interest rates.

"Why should I hold something that's 4% [interest rate] before inflation, that's not the greatest yield. I think that's one reason [bond] prices are slipping and yields are going up... I'd buy stocks over any of this fixed income. I think they're both going to go up. I think the yields will go down. But you're going to get a bigger bang for your buck in the stock market," he concluded.