'Stock Market Upside Is Very Much Capped As Federal Reserve Looks To Raise Rates More Than Expected'

According to former New York Fed President Bill Dudley, financial markets are underestimating how aggressive the Federal Reserve is, which might limit the potential gains for investors.

Following Fed Chairman Jerome Powell's statement on Wednesday that future rate hikes are expected to moderate as policy tightens, stocks surged as investors anticipated a dovish tilt following an aggressive sequence of rate increases.

Stocks rose after Fed Chairman Jerome Powell suggested Wednesday that a future slowdown in rate hikes is anticipated as policy tightens, with markets anticipating a dovish shift following an aggressive sequence of increases.

However, Dudley told Bloomberg TV that Powell's statements were not dovish. Instead, he cited Powell's previous remarks, specifically that rates must rise over a neutral level to be somewhat restrictive and that the danger of doing so is high.

"I think the markets' upside is very much limited by the fact that the Federal Reserve requires tighter financial conditions to generate the slack in the labour market that we don't have today," Dudley said.

In fact, he sees a long runway for the Fed's tightening and predicts that rates would eventually rise to a terminal level of around 4%, up from 2.25 -2.50 % today.

He also mentioned that Powell cited the Fed's Summary of Economic Projections — called the "dot plot" — as a rate-setting guidance. Policymakers expect the federal funds rate to reach 3.25 percent -3.5 percent by the end of this year, then rise another 50 basis points the next year, according to estimates. Others on Wall Street, though, are optimistic that the Fed will reverse its tightening, maybe as soon as later this year.

Following Powell's remarks, Pantheon Macroeconomics senior economist Ian Sheperdson wrote in a note that the Fed may consider a rate cut in September because "all gauges of supply chain pressures and prices have eased considerably in recent months."

Meanwhile, the prices of essential commodities such as gasoline have fallen significantly from their highs, encouraging hopes that inflation may decline shortly and relieve some of the Fed's pressure.

However, Dudley believes markets are mistaken in believing the Fed will change course and warns against further stock bullishness.