RPT-COLUMN-Trump's fresh Fed attack simmers in markets: Mike Dolan

By Mike Dolan

LONDON, July 15 (Reuters) - Markets either don't believe the White House attempts to force out the Federal Reserve chair will succeed, or they assume it's all bluster. But there's good reason to be wary of the sort of uncertainty that renewed Fed-bashing may be building under the surface.

Donald Trump's verbal attacks on Fed boss Jerome Powell have been relentless since he returned to the White House in January and are now almost daily. The latest sideswipes include demands for an immediate rate cut of more than 3 percentage points.

Until June, Trump had claimed he would not fire Powell before his term expires early next year, a move the Supreme Court has suggested might be legally contentious. The focus had instead turned to Trump announcing Powell's successor early, creating a "shadow" Fed boss who would undermine Powell's credibility in markets.

But a new and sharper tack has emerged over the past month, with White House officials now lambasting Powell for presiding over spending overruns in a renovation of Fed headquarters in Washington and calling on him to take responsibility.

The twist inevitably rekindles talk of Powell's early ouster.

Speculation swirled on Friday that Powell may be forced to resign and White House economic adviser Kevin Hassett, seen by some as one possible contender to replace Powell, said on Sunday that Trump had the authority to fire Powell "for cause" and the Fed is accountable for its HQ renovation costs.

Hassett said the decision would largely depend on the Fed's answers to questions from budget director Russ Vought about the alleged $700 million cost overrun.

In response, Powell on Monday asked the central bank's inspector general to review the renovation spending.

KNEE JERK

Betting markets have certainly spied the renewed risk. The Polymarket site shows punters assigning a one-in-five chance of Trump removing Powell this year compared to just a 10% probability this time last month.

And yet interest rate markets appear, on the face of things at least, relatively calm about the implications for policy.

Right now, just two Fed rate cuts are priced into the futures curve this year and the entire Fed easing cycle is seen to bottom out next year at about 3.2% - less than 120 basis points below current rates and well shy of the 300 bps demanded by Trump.

And that horizon right out to a "terminal rate" trough in early 2027 is actually some 20 bps higher than it was at midyear - just two weeks ago.

That's partly down to resilient economic readings, partly on worries about price rises from the new August 1 tariff cliff edge and partly on perceptions that ramping up political pressure for Fed easing may have a counterproductive effect.

Investors do not currently believe that firing Powell would change the Fed's economic policy over the next year, unless the economy itself takes a dramatic turn for the worse.

Morgan Stanley economist Seth Carpenter said he sees no change in the Fed's "reaction function" between now and next May despite the shadow chair debate.

Trump can't easily control the Fed's decisions just by firing its chair. There are two main defenses against this: First, the chair doesn't decide policy alone, and second, their leadership role on the main committee is only a tradition, not a law.

What's more, he says history suggests political appointees - not least Powell himself after Trump nominated him as chair in 2018 - tend not to carry favors into office. "Political appointees tend to shed past allegiances and work toward the institution’s legislative mandate," he said.

UNDER-PRICED RISK

On the other hand, Deutsche Bank's currency strategist George Saravelos makes the case that while the market may be sanguine about Trump's early naming of a shadow Fed chief, it's not priced for Powell's sudden removal or forced resignation this year.

"We consider the removal of Chair Powell as one of the largest under-priced event risks over the coming months," he wrote.

"The market reaction would be large," said Saravelos, adding 3%-4% dollar losses and 30-40 bp spikes in Treasury yields could be seen within 24 hours. "It is stating the obvious that investors would likely interpret such an event as a direct affront to Fed independence putting the central bank under extreme institutional duress."

The crux of thinking is less about what it means immediately for Fed futures pricing than what Powell's forced exit would mean for longer-term calculations about political pressure on monetary policy.

If Trump breaks the long-standing precedent of central bank independence, he would make long-term debt holders question the Fed's reliability. They would also start to doubt what level of inflation the Fed will tolerate over time - and not even just under Trump.

If investors start to believe the government will always push for low interest rates, they then have to take on board the risk of higher inflation. And even if not, the uncertainty around where inflation may be longer term should rise to the point where investors need to demand a higher risk premium to compensate.

Fed papers show markets are already displaying far greater uncertainty over the direction of rates over the next five to 10 years than they did in 2019 - and still show an almost one-in-10 chance of a return to zero interest rates over that time frame.

Higher long-term inflation expectations are negative for the dollar, especially if met with looser monetary policy.

And a big risk then is a correlated spiral of dollar and Treasury bond losses - spooking overseas and domestic debt holders alike. The return of 30-year yields back toward 5% on Monday was one of the few clear market moves after the weekend.

With core inflation running about 3%, 10-year market inflation expectations still well above target at about 2.4%, import tariff hikes and worker shortages coming down the pike, Trump's preference for interest rates of 1% or less should raise concerns about where inflation finally pans out.

The opinions expressed here are those of the author, a columnist for Reuters