“They want a weaker stock market. They want higher bond yields,” Dudley said. “The stock market I think is finally catching onto that.”
The Fed came to the rescue in March 2020 by slashing interest rates to zero and promising to purchase trillions of dollars in bonds. Those moves laid the foundation 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 unwinding those emergency policies – and that will be a challenge for markets.
Fed policy is keyed in part to financial conditions. When the economy needs help, the Fed 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 reacting because it makes their job 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 already getting tougher, the Fed would have to telegraph even more dramatic steps.
“The Fed has to be pleased by the fact that the change in their monetary policy plans has started to affect bond and stock prices in a way that will make it easier for them to get control over an overheated economy,” Dudley said.
Is the market underestimating the Fed?
Of course, Fed officials don’t want to panic investors in a way that crashes the market. That could slow down the economy too much by dealing a blow to confidence among consumers and CEOs.
“That’s why soft landings are so difficult to pull off,” Dudley said.
Investors have sharply increased their expectations for how high interest rates will have to go to get inflation under control. And yet Dudley said Wall Street may need to adjust its forecasts even higher given the scale of the inflation problem.
“I think the market still probably is a little bit underpricing where the Fed is ultimately going to have to go in the second phase of monetary policy,” Dudley said. “I think they have to actually start to make monetary policy tight in 2023. I don’t think the market fully understands that yet.”