“They want a weaker stock market. They want higher bond yields,” Dudley said. “I think the stock market is finally figuring that out.”
The Federal Reserve came to the rescue in March 2020 by cutting interest rates to zero and promising to buy trillions of dollars of bonds. Those moves set the stage for blockbuster returns in the stock market, gains that helped revive confidence in the US economy after the onset of Covid-19.
Now the Fed is undoing those emergency policies, and that will be challenging for the markets.
The Fed’s policy depends in part on financial conditions. When the economy needs help, the Federal Reserve loosens its policies, making it cheap and easy to borrow money and pushing investors to focus on riskier stocks instead of boring bonds.
‘The Fed has to be pleased’
Dudley said current Fed officials will be encouraged to see the market react because it makes their jobs easier.
“The less the market reacts to the Fed, the more the Fed has to do. The more the market reacts, the less the Fed has to do,” Dudley said.
In other words, if financial conditions weren’t getting tougher, the Fed would have to telegraph even more dramatic steps.
“The Fed should be pleased that the change in their monetary policy plans has begun to affect bond and equity prices in a way that will make it easier for them to rein in an overheated economy,” Dudley said.
Is the market underestimating the Fed?
Of course, Fed officials don’t want to scare investors in a way that collapses the market. That could slow the economy too much by dealing a blow to confidence among consumers and CEOs.
“That’s why soft landings are so hard to pull off,” Dudley said.
Investors have sharply raised their expectations about how high interest rates will have to be to control inflation. And yet, Dudley said Wall Street may need to adjust its forecasts further given the scale of the inflation problem.
“I think the market is still probably a bit undervalued where the Fed will eventually have to go into phase two of monetary policy,” Dudley said. “I think they actually have to start tightening monetary policy in 2023. I don’t think the market fully understands that yet.”