The Fed needs to 'inflict more losses' on the stock market in order to rein in soaring inflation, former Fed president Bill Dudley says

• The Federal Reserve will need to "inflict more losses" on the stock market to rein in inflation, former Fed President Bill Dudley said on Wednesday.
• Dudley believes the Fed needs to tighten financial conditions, and the only way to do that is to hike interest rates by a substantial amount.
• "Investors should pay closer attention to what Powell has said: Financial conditions need to tighten," Dudley said.

Federal Reserve Chairman Jerome Powell will need to shock investors and hurt the stock market in order to tamp down surging inflation, former Fed President Bill Dudley said in a Bloomberg Op-ed on Wednesday.

"One thing is certain: To be effective, [The Fed] will have to inflict more losses on stock and bond investors than it has so far," Dudley said.

Already investors likely feel whiplashed by the Fed, given that last year's expectations for interest rate hikes was at zero. Now, investors expect up to 8 interest rate hikes by the Fed by the end of this year. The Fed already hiked interest rates by 0.25% last month, its first rate hike since late 2018.

But while the Fed ended certain stimulus measures, raised interest rates, and telegraphed to the market that more increases are coming, the stock market has barely budged. The S&P 500 is down about 5% from its peak in early January, and the 10-Year Treasury note's yield of about 2.63% is up just 0.75 percentage points from a year ago and still well below the inflation rate.

"This is happening because market participants expect higher short-term rates to undermine economic growth and force the Fed to reverse course in 2024 and 2025 — but these very expectations are preventing the tightening of financial conditions that would make such an outcome more likely," Dudley said.

The Fed's ultimate goal is to tighten financial conditions to help rein in demand from consumers, and in turn, help reduce the going rate of inflation, which hit 40-year highs last month.

If the Fed is unable to tighten financial conditions on its own, "the Fed will have to shock markets to achieve the desired response," Dudley said.

"This would mean hiking the federal funds rate considerably higher than currently anticipated. One way or another, to get inflation under control, the Fed will need to push bond yields high and stock prices lower," Dudley said.

One area where the Fed is succeeding in tightening financial conditions for consumers is mortgage rates, which jumped across the 5% level yesterday. That surge in interest rates has led to a 40% year-over-year decline in new mortgage applications, and has put pressure on homebuilder stocks and lumber commodity prices.