Fed Watch: How Policy Uncertainty Fuels the Stock Rally – And Why Caution Remains

The U.S. stock market’s recent rally has investors asking: Is this a sustainable rebound, or a fleeting illusion fueled by Fed whispers? With the Federal Reserve’s May meeting confirming a “wait-and-see” approach to interest rates, traders are pricing in a potential June cut while navigating a choppy economic landscape. Here’s why the Fed’s calculus—and the risks it overlooks—matter more than ever.

The Fed’s Tightrope Walk

The Federal Reserve’s decision to hold rates steady at 4.25%-4.5% in late May 2025 underscored its struggle to balance two competing forces: rising inflation pressures and a fragile economy. While the central bank’s “dot plot” now projects two rate cuts by year-end—trimming the federal funds rate to 3.88%—its immediate hesitation reflects a stark reality: trade wars are destabilizing growth.

President Trump’s aggressive tariff policies have created a double-edged sword. On one hand, businesses rushed to stockpile goods ahead of tariff hikes, driving a 41.3% surge in imports in Q1 2025 and sparking a GDP contraction of -0.3%—the largest drop since 2022. On the other, these tariffs are now feeding into inflation: core PCE prices, the Fed’s preferred gauge, hit 2.6% year-over-year, exceeding its 2% target.

Why Stocks Are Rallying—and What Could Derail It

The S&P 500’s 5% gain since March 2025 isn’t just about Fed dovishness. It’s also a bet on forward-looking optimism: traders are pricing in the eventual easing of trade tensions and a rebound in consumer spending once tariff-driven uncertainty fades.

But this rally faces three critical risks:
1. Geopolitical Volatility: Retaliatory tariffs from U.S. trading partners could escalate, amplifying supply chain bottlenecks.
2. Labor Market Resilience: While April’s 130,000 job gains were softer than March’s 228,000, the unemployment rate remains near 4.2%—a level the Fed considers “full employment.” Persistent hiring could force the central bank to pause its planned cuts.
3. Corporate Earnings Softness: With input costs rising due to tariffs, profit margins for sectors like manufacturing (think caterpillar or Boeing ) could compress further.

The Fed’s Political Bind

Don’t overlook the elephant in the room: political interference. President Trump’s public criticism of Fed Chair Powell—calling him “a major loser”—has clouded the central bank’s independence. Meanwhile, the Supreme Court’s review of the Fed chair’s tenure could redefine monetary policy’s trajectory.

This uncertainty is already pricing into markets. The 10-year Treasury yield has dropped to 4.25%, signaling investors are prioritizing growth stability over inflation fears. Yet, the Fed’s delayed response to tariff-driven inflation risks a repeat of 2023’s “whipsaw” volatility, where hopes of cuts were dashed by stubborn price pressures.

Conclusion: A Rally Built on a Precarious Foundation

The stock market’s May rebound is no accident—it’s a gamble on the Fed’s ability to navigate tariff chaos and engineer a soft landing. But the data tells a cautionary tale:

• The Fed’s 2025 GDP forecast of 1.7% is a downgrade, and two rate cuts may not be enough to offset a -0.3% Q1 contraction.
• With core PCE at 2.6%, inflation is still above target, leaving little room for error if tariffs reignite price spikes.
• The market’s 60% pricing of a June cut hinges on a jobs report that’s “weak enough” to justify easing—a high-stakes balancing act.

Investors should treat this rally as a buying opportunity with an expiration date. Diversification into inflation-hedged sectors (e.g., energy stocks like ExxonMobil ) and short-term Treasuries could mitigate the risks of a Fed misstep. As the Fed’s own projections show: growth is fragile, and policy is a guessing game.

Comparison of Fed’s 2024 vs. 2025 GDP and inflation forecasts

In short, the rally isn’t over—yet. But with trade wars and political storms on the horizon, the next Fed meeting could be the moment the market’s optimism finally collides with reality.