Bill Gross Predicts a 3.5% Fed Funds Rate

Bill Gross' November market commentary is up on the PIMCO website. In it he pokes fun at Citigroup CEO Chuck Prince for his colorful commentary back in July regarding potential exposure to bad private equity-related debt: "As long as the music is playing you've got to get up and dance. We're still dancing." Turns out Prince probably should have stopped dancing, or at least kept his mouth shut. Investors probably won't look to kindly upon Prince dancing his way to a $6.5 billion writedown.

More important than Chuck Prince however is Gross' outlook on the US economy going forward and particularly his outlook on what Bernanke must do to bail us out:

So both old-fashioned banks and their derivative, conduit-fed shadow counterparts will be growing their balance sheets a lot more slowly in future months and quarters. That rather immediately translates into a slower economy and the need for government assistance in the form of lower interest rates or liquidity pushes like Treasury Secretary Paulson’s “Super SIV.” Whether Paulson’s “Committee to Save the World – Part II” will succeed like Bob Rubin’s original during the Long Term Capital crisis is debatable. The idea, first of all, is counterproductive because it continues to hide subprime asset prices in the “shadows.” Secondly, Rubin confronted no regulatory headwinds back in 1998, nor did he have to deal with today’s behemoth shadow banking system in the process of losing its brave face. Rubin in fact, along with his all-star committee featuring Alan Greenspan and Larry Summers, had a near hurricane force tailwind with 24 months more of dotcom IPOs yet to come. No wonder that Chairman Greenspan needed to cut short rates by only 75 basis points before stabilizing the economy nearly a decade ago.

Ben Bernanke has no such luxury. While he does have the backstop of a global economy powering on at a 4-5% annual clip, today’s U.S. IPOs were more a creation of leverage and the shadow banking system’s ability to create productivity gains through finance, as opposed to technological innovation. With banks and their shadows in retreat and modern day “world saving committees” relatively impotent, Bernanke must do some heavy lifting as opposed to the light housework required of Alan Greenspan in 1998. An increasingly recessionary looking U.S. economy will likely require 1% real short rates and 3½% Fed Funds in order to stabilize a potential growth contraction in lending not witnessed since the early 1970s or, to be honest, Roosevelt’s depressionary 1930s.

So here at the beginning of another Fed week we should look for another 50 basis point cut in the Fed Funds rate as Bernanke seeks to preempt further weakness. This would still leave another full percent for Bernanke to cut before approaching the 3.25% that Gross is predicting. While the smart money is on a 25 basis point cut, I'm going to break from the mold and predict a larger move. Look for this cut to further weaken the dollar and lead to another commodity rally. It is now within the realm of possibility that oil could reach $100 before a cyclical slowdown in the winter. While $100 a barrel oil seems amazing, this isn't the first time we have seen it before. Below is a graph courtesy of James Hamilton at Econbrowser:

Dollar price per barrel of West Texas Intermediate divided by ratio of CPI for the indicated month to the present value.

The other thing to look for is for a major announcement from a foreign central bank that they are officially removing their dollar peg. There is already a great degree of consensus among Gulf executives that removing the dollar peg would help their economies. Of the six major economies in the Gulf region, five -- Saudi Arabia, Oman, Qatar, Bahrain and UAE -- maintain a dollar peg. The sixth, Kuwait, removed their peg in May. All are dealing with serious inflation issues, and are unable to fight against the inflation because of the devaluing dollar.