Bill Gross, manager of the world's largest bond fund, Monday said that the subprime mortgage crisis will dominate Federal Reserve policy "over the next several years" and believes short-term U.S. interest rates could fall to 3-3/4 percent over the next six to 12 months.
The Fed "could but probably won't" cut the overnight federal funds target rate twice in half-percentage-point increments by the end of the year, added Gross in his October investment outlook report.
Gross said the downward path of home prices "will dominate Fed policy over the next several years as will the lingering unwind of related financial structures and derivatives that have yet to be discovered by the public, and marked to market by their conduit holders."
On Sept. 18, the Fed cut interest rates by an agressive half-percentage point to 4-3/4 percent in an attempt to shelter the economy from the turmoil in the credit and housing markets.
But Gross said rate cuts might not cushion the blow in housing. Home prices have been declining for nearly 12 months and "only now is the Fed responding to an unfolding crisis," he said.
Moreover, Ben Bernanke, chairman of the central bank, faces a new market phenomena of globalization and financial innovation, which have enormously complicated the job of central bankers, he said.
"Whereas in prior decades a 'one size fits all' policy rate move has coincidentally and democratically affected households and corporations alike, the 21st century has ushered in an innovation revolution favoring corporations with global investment opportunities as opposed to individuals with daily bills to pay."
"The same 4 3/4 percent rate is not and cannot be 'neutral' for both sides in today's U.S. economy," he added. "Whereas current yields are not restrictive for investment-grade corporations with global opportunities, they are far too high for homeowner Jane Doe and two million of her neighbors facing higher and higher monthly payments on adjustable rate mortgages."
Even Treasury Secretary Henry Paulson appears to be underestimating the vulnerabilities of the banking system, said Gross.
Traditional banking activity -- lending out deposits backed by a certain level of reserves -- was the accepted vehicle for liquidity creation.
"But financial innovation has done an end run around the banks," Gross said. "Derivatives and structures with three- and four-letter abbreviations -- CDOs, CLOs, ABCP, CPDOs, SIVs (the world awaits investment banking's next creation; perhaps IOU?) -- can now take a 'depositor's' dollar and multiply it 10 or 20 times."
In sum, reserve banking, and the Federal Reserve that regulates the system, appear "anemic in comparison," he added.
"I'm sure that Bernanke, Paulson, and their cohorts understand this, but it isn't yet clear how much they appreciate it," Gross said.
He noted that former Fed chairman Alan Greenspan admits in his newly published book that he did not appreciate until recently the impact adjustable-rate mortgages and their subprime character, accompanied in some cases by outright fraud, would have on the housing market.
"If the Fed was so slow to grasp the role that subprime mortgages played in the housing boom and bust, do the Fed and the Treasury of today totally comprehend what happens when the nonbanking private system suddenly stops flooding the market with credit?"