Stock market rise ‘very capped’ as Federal Reserve seeks to raise rates more than expected, says former New York Fed chairman

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  • Wall Street is underestimating further rate hikes from the Federal Reserve, according to Bill Dudley.
  • The former head of the New York Fed told Bloomberg TV he thinks the terminal rate is around 4%.

Financial markets are underestimating the Federal Reserve’s aggressiveness, which could limit the upside for investors, former New York Fed Chairman Bill Dudley said.

Stocks jumped after Fed Chairman Jerome Powell said on Wednesday that a future slowdown in rate hikes is likely as policy becomes more restrictive, with markets pricing in a dovish pivot to follow an aggressive cycle of rises.

But Dudley said Bloomberg Television that he did not interpret Powell’s comments as dovish. Instead, he pointed to Powell’s other comments, in particular that rates must rise above a neutral level to be moderately restrictive and that the risk of doing too little to fight inflation is greater than the risk of to overdo.

“I think the market upside is largely limited by the fact that the Federal Reserve needs tighter financial conditions to generate the labor market downturn that we don’t have today,” Dudley said.

In fact, he sees a long run for Fed tightening and the expected rates will eventually climb to a terminal level of around 4%, from 2.25% to 2.50% currently.

He also pointed out that Powell pointed to the Fed’s summary of economic projections — aka the “dot chart” — as a guide on rates. Projections indicate that policymakers expect the fed funds rate to reach 3.25% to 3.5% by the end of this year, then climb another 50 basis points next year.

But others on Wall Street hope the Fed will reverse its tightening, perhaps as early as the end of this year.

Pantheon Macroeconomics chief economist Ian Sheperdson wrote in a note following Powell’s comments that the Fed may consider a September rate cut because “all measures of supply chain pressures and costs have diminished markedly in recent months.

Meanwhile, the costs of key commodities like gasoline have also spiked, raising hopes that inflation will soon ease and relieve the Fed.

But Dudley said markets were wrong to think the Fed would backtrack and warned of further bullish stocks.

“Let’s assume the stock market rallies another 5% to 10% from here, I would see that as kind of undermining what the Federal Reserve is trying to accomplish,” he said.

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