Stock market upside is 'very much capped' as the Federal Reserve looks to raise rates more than expected, says former New York Fed president

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

Financial markets are underestimating the Federal Reserve's hawkishness, which could limit the upside for investors, said former New York Fed President Bill Dudley.

Stocks jumped after Fed Chairman Jerome Powell said Wednesday that a future slowdown in rate hikes is likely as policy gets more restrictive, with markets anticipating a dovish pivot will follow an aggressive cycle of increases.

But Dudley told Bloomberg TV that he didn't interpret Powell's comments as dovish. Instead, he pointed to Powell's other comments, in particular that rates need to go past a neutral level to be moderately restrictive and that the risk of doing too little to fight inflation is greater than risk of doing too much.

"I think the upside for the markets are very much capped by the fact that the Federal Reserve needs tighter financial conditions to generate the slack in the labor market that we don't have today," Dudley said.

In fact, he sees a long runway for the Fed's tightening and predicted rates will eventually climb to a terminal level of about 4%, up from 2.25%-2.50% now.

He also highlighted that Powell pointed to the Fed's Summary of Economic Projections — aka the "dot plot" — as a guide on rates. The projections indicate that policymakers expect the federal funds rate will reach 3.25%-3.5% by the end of this year, then climb another 50 basis points next year.

But others on Wall Street are hopeful that the Fed will reverse its tightening, perhaps even as soon as later this year.

Pantheon Macroeconomics chief economist Ian Sheperdson wrote in a note following Powell's comments that the Fed could eye a rate cut in September, because "all measures of supply chain pressures and costs have eased markedly in recent months."

Meanwhile, the costs of key commodities like gasoline have also come well off highs, raising hopes inflation will ease soon and take some pressure off the Fed.

But Dudley said markets are wrong to think the Fed will reverse course and warned against more stock bullishness.

"Say the equity market were to rally another 5 to 10% from here, I would view that as sort of undermining what the Federal Reserve is trying to accomplish," he said.