Hedge fund billionaire Paul Tudor Jones, who called the October 1987 crash, believes markets are in a dangerous financial bubble thanks to Federal Reserve's "obsession" with inflation targeting.

The investor lambasted what he called an "arbitary" 2 percent inflation target set by the central bank, a goal he views as both outdated and dangerous.

"We are in the throes of a burgeoning financial bubble," Jones warned clients in a note obtained by CNBC. "In the U.S., this obsession on inflation targeting has lately been taken to a new level as former Fed Chair Ben Bernanke has floated the idea of a price-level targeting mandate for the Fed. That means the central bank would allow inflation to remain above 2 percent to 'make up' for periods when inflation is too low."

His warning to clients came on Feb. 2, the day when a chaotic sell-off in the market began.

Jones is a reclusive hedge fund legend who never talks to the press. So much so that "PTJ" even tried to bury a PBS documentary featuring him from 1987 by purchasing all the available copies.

The longtime investor added that since 1970, the very long-term average of inflation is 1.9 percent, but that the average is biased upward by war-time inflation spikes, implying that a better target maybe be significantly lower. A lower target would almost certainly give the Fed the confidence to quickly hike rates at the economy's current level of production.

"If I had a choice between holding a U.S. Treasury bond or a hot burning coal in my hand, I would choose the coal. At least that way I would only lose my hand," Jones joked. "The peacetime, long-term 10-year real rate of interest that has determined the efficient allocation of capital between lenders and borrowers averaged 3.5 percent for centuries."

With the economy either at or beyond full employment and the consumer price index — a measure of the inflation in consumer prices — at 2.1 percent, the real 10-year interest rate is 0.4 percent, Jones explained, roughly 300 basis points below the historical average.

Equity markets, too, have undergone a historic rally. Despite a turbulent start to February, both the Dow Jones industrial average and S&P 500 clinched a slew of all-time highs in 2017, giving new life to the conversation around an improving economy and creeping inflation.

"We are replaying an age-old storyline of financial bubbles that has been played many times before," he concluded. "I believe policymakers should have been much more aggressive in tightening policy and rejecting the fiscal impropriety associated with this most recent tax cut ... The die has been cast by the Fed and other central banks and future policy prescriptions are predictable."