Pimco's Gross: Fed to Cut Key Rate 1/4 Point Tuesday

The Federal Reserve is likely to cut the federal funds rate by a quarter point and the more symbolic discount rate by a half point at next week's meeting, PIMCO's Bill Gross told CNBC.

Gross, manager of the world's largest bond fund, made his prediction after earlier saying that the Fed could be forced to lower interest rates below 3 percent next year to avoid a
recession. The federal funds rate is currently 4.5%, while the discount rate is 5%.

Bill Gross
Bill Gross

"It really is a divided Fed," Gross said in the CNBC interview. "There are hawks still and there are doves...Nevertheless, twenty five basis points in terms of fed funds is probably the call. I'd look for 50 basis points in terms of the discount rate to solve that liquidity situation."

The federal funds rate, which is what banks charge one another for short-term loans, influences a host of consumer interest rates. The discount rate, which is what the Fed charges banks for short-term loans, is more symbolic but has taken on greater significance because of the credit crunch that has swept financial markets since last summer.

Gross, who runs the $111 billion Pimco Total Return fund, told Reuters earlier that the final determination of next week's Fed meeting depends largely on Friday's nonfarm employment report from the U.S. Department of Labor.

Until then, though, a much stronger-than-expected reading of private employer job growth, reported Wednesday morning, has to be taken into account.

In his latest investment outlook note to clients, Gross said the federal funds rate needs to fall to 3 percent or less to restart a "near-recessionary economy."

Home prices, already down 5 percent nationwide, could drop another 10 percent over the next several years, said Gross.

While yields on Treasuries have dropped dramatically on expectations of further rate cuts, Gross said added that that has not translated into lower borrowing costs for consumers, homeowners and corporations, which need it most.

Furthermore, Gross said the Fed needs to lower rates to cushion the deterioration in the financial-services sector.

"The Fed needs to bring fed funds levels down steadily and significantly more in order to counteract the contraction of the shadow banking system which has imposed, and will continue to require, higher risk premiums for non-Treasury securities in an increasingly risky financial environment," said Gross.

The shadow banking system Gross is referring to is "essentially the breakdown of our modern day banking system, a complex of levered lending so hard to understand that Fed
Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August."

Gross told Reuters in a follow-up e-mail interview that he has been a buyer of Fannie Mae and Freddie Mac mortgage-backed securities.

"We are comfortable with agency credit and have been buying agency MBS," he added. Gross noted that agency-guaranteed mortgages, reflecting higher levels of assumed volatility,
present "150 to 175 basis point pick-ups."