The Federal Reserve could be forced to lower interest rates below 3 percent to avoid a recession, Bill Gross, the manager of the world's biggest bond fund, said on Wednesday.

In his latest investment outlook note to clients, Gross said the federal funds target rate, currently at 4.5 percent, needs to fall to 3 percent or less to restart a near-recessionary economy.

Gross, who runs the $111 billion Pimco Total Return fund, said in an e-mail response to a question from Reuters that he expects the Fed will lower benchmark interest rates by just one-quarter of one percentage point at next week's meeting of monetary policy makers.

Gross said the final determination 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.

Home prices, already down 5 percent nationwide, could drop another 10 percent over the next several years, said Gross, the chief investment officer at Pacific Investment Management Co., or Pimco.

While yields on Treasuries have dropped dramatically on expectations of further rate cuts, Gross 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.

(Editing by Jonathan Oatis)

Investment