Bill Gross, founder and managing director of Pimco, discussed interest rates, recession and government intervention with Chrystia Freeland, the FT’s US managing editor. You can also read his comments about investments, Muhamed El-Erian and subprime here.

FINANCIAL TIMES: Thank you for joining us, Mr Gross.

BILL GROSS: My pleasure. Thanks for coming out!

FT: Where do you see US interest rates going?

MR GROSS: That’s a good question. They have to go low enough in order to provide a floor for housing prices. The real problem here in the United States is now one of the property deflation, and we’ve seen that example in Japan in the late ’80s and the 1990s and what it can do for an economy. It can basically produce a very stagnant, if not deflationary, economy for a number of years if you let it unwind. Same thing happened in the Depression.

Bernanke’s a student of both of those particular historical examples and we’re confident, quote-unquote, that he recognises the need to lower interest rates in order to support housing prices on the downside.

What’s the appropriate rate? Well, the Fed is feeling its way along. I have a sense that they should’ve done more than crawl their way along in terms of lowering interest rates. As a matter of fact, I think they raised rates too high. The five and a quarter percent short-term rate was probably inappropriate fper centr the US housing market. It might have been more than appropriate for the global marketplace, but here, in the United States, in terms of housing prices, it couldn’t be supported with the ultimate 7 and 8 and 9 per cent subprime rates that resulted from that.

So, you know, I suspect they have to go down to at least 3 per cent and maybe more. The –

FT: When do you see that happening?

MR GROSS: Oh, I think around the next six months. And I think they need to move rather quickly in order to prevent a 10 to 15 per cent decline in housing prices.

FT: What about the argument that if the Fed does take rates that low, it’s just setting everyone up for yet another asset bubble? That there really hasn’t been enough fat squeezed out of the system yet.

MR GROSS: I think that’s true. I mean, that’s very much the –

FT: But yet you think the Fed should do it so –

MR GROSS: Well, I think they have no choice. You know, the question that you pose really centres around the Austrian thesis, in which it’s necessary for recessions to occur for asset prices to be liquidated in order to start anew. And I think there’s a semblance of logic and common sense to that.

It’s just that we’ve gotten to the point and backed ourselves into a corner so many times that the pain may be too much to bear for, not only the American economy, but the global economy, because of the interconnection.

So, you know, it’s not that that’s not an appropriate policy of eventually forcing the US economy to endure some pain. It’s simply my opinion that, perhaps policymakers won’t be willing to go that far.

FT: Absent the right policy actions, how bad do you think things could get right now?

MR GROSS: Well, I think we’re headed for a mild recession if housing prices can be floored at a negative 10 per cent. If things snowball on the downside and if problems occur in other credit-related areas, conduit-related areas, you know, associated with asset classes other than mortgages, municipal bonds, for instance, might be under threat if monoline insurers, because of the subprime crisis, lose their ratings and are unable to guarantee municipal securities.

So there’s all types of interconnections that are dependent upon a hoped-for solution in many of these areas.

I think the commonsensical, most probabilistic outcome is for a mild recession at some point in 2008, and a gradual recovery based upon monetary stimulation and, hopefully, some type of fiscal push as well. If, in fact –

FT: So you think there will be an actual recession? Growth will actually go into negative territory?

MR GROSS: I think so. You know, if I had to be bold, and I can do that, a la Dow 5,000, if I had to be bold, I’d say we began a recession in December.

FT: So we’re in a recession now. How long is it going to last?

MR GROSS: I think for four or five, six months. I mean that’s the definition, technically, of a recession. If it was only going to be a down month or two, then even the NBER wouldn’t classify it as a recession.

So I think, you know, through the first of half of 2008 and then we’ll simply have to see what the policy responses are. If the Fed doesn’t drop interest rates down to 3 [per cent], which is what I think is required, if the Bush Administration and Congress don’t, you know, take some rather unperceived and un-forecasted measures in terms of fiscal stimulation then we simply sort of stay here.

FT: You’ve talked about the Fed needing to lower rates to at least 3 per cent. What’s the impact on the US dollar if that happens?

MR GROSS: Well it hasn’t been positive, certainly, because the forward markets are already forecasting a decline in terms of funds down to three-and-a-quarter or three-and-three-eighths. So we’re actually almost there in terms of the forward markets and the dollar is a reflection of those forward markets in terms of hedging.

So it hasn’t been a positive – you know, I would say on the positive side, that if you could be successful in terms of stopping the housing price decline, if you were successful in curtailing the recession in a mild type of sense over a six-month period of time, then dollar-holders would certainly be encouraged, and they might even begin to look forward to a recovery as opposed to a recession.

So, yeah, the 3 per cent rate is obviously not an attractive carry in terms of holding dollars, much like with the Japanese yen. A 50 basis-point rate is not an attractive carry either, and that’s part and parcel of the evaluation.

So it hasn’t been a positive. I think from this point forward, though, at least in comparison to euroland markets and the UK, that the dollar is probably in decent shape.

FT: So the dollar has hit bottom?

MR GROSS: Well, just relative to those currencies. And that factors in, in our opinion and my opinion, that the UK is, sort of, a US lookalike, the twin sister, so to speak. Their economy is financed-based much like ours is. They basically make paper as opposed to things, and as the financed-based economy implodes, then the economies that are the most financed-based are the most vulnerable.

And so the UK’s next. The pound has done so well and I think at this point, relative to the dollar at least, that it’s due for a come-uppance.

FT: And what about the risk of inflation? How much of a problem do you see that as?

MR GROSS: I don’t. You know, obviously I was disturbed –

FT: You don’t. No, no danger there? Commodity prices notwithstanding?

MR GROSS: Obviously, there’s some danger and the November numbers were not good numbers and I would’ve preferred to turn on my TV set and, you know, see something better and more optimistic.

But the fact is that when an economy slows down from a cyclical standpoint, the next two years, the next 24 to, actually, 36 months, are periods of time in which inflation actually goes down. That’s because capacity is increased, unemployment goes up, you become an economy that is very price-sensitive because the goods aren’t being absorbed.

FT: Larry Summers has been talking about the need for much more forceful government action right now on the economy, including fiscal measures. Do you think he’s right?

MR GROSS: I do. You know, the US economy has been pumped for so many years, primarily asset-pumped and with monetary policy, and to a certain extent with fiscal policy with tax cuts.

The combination led to the stock market bubble, the dotcom bubble, the deflating of that bubble, the re-flating of the economy with the housing bubble - but there’s really not an asset class left to inflate.

The fact is that we need fiscal stimulation and we need our deficit to expand from 2 per cent to perhaps as high as 4 or 5 per cent in order to fill in the gap, to fill in the consumption gap and the gap from asset deflation, that we’re experiencing and will experience for the next 12 to 24 months.

FT: As a registered Republican are you confident that Hank Paulson and George Bush are in a position to do that?

MR GROSS: No, it’s an awkward time for, not only Republicans but Democrats. It’s an election year coming up, and that introduces whole different types of intrigues in terms of timing. Not to say that both parties aren’t really willing to save the economy and to save jobs - they are. But the inevitable delays and nuances in terms of differences play out in an election year, waiting for the next president and the next Congress to save the day.

And so this is an inopportune time, really, for the problems and this mild recession which I’m forecasting to take place.

FT: Do people in Washington get that, though? Do they understand that, notwithstanding the political delicacy of the moment, they have to do something?

MR GROSS: Not yet. I don’t think. You know, to the extent that measures taken to date, you know, the temporary fix in terms of the Super-Siv, the teaser – I forget what they call it – the teaser freezer! The teaser freezer, you know, those types of provisions by Paulson and the Administration - those are all well and good, but they’re really band-aids, and what needs to be done is something fairly radical compared to Republican orthodoxy. Which means, spend money and absorb the deficit, as opposed to pretending, at least, that you’re fiscally conservative.

FT: You’ve been a strong critic of this Super-Siv Fund. Were you asked to manage it?

MR GROSS: No. We weren’t, and I think probably because I was a critic. I mean, why would the administration come to Pimco after having been criticised for the concept? So that’s, I guess that’s part and parcel of being outspoken. It comes with the territory and if that was the case - and I don’t know that that was the case - then I apologise to all my partners for being so outspoken. Sorry!

FT: Do you think that the credit crunch has discredited some of the more complicated financial instruments, some of the more complicated financial innovation we had seen in preceding years?

MR GROSS: Oh, definitely. I mean, and here’s a good debate that we’ve had with Alan Greenspan when he’s come out here. He’s been a proponent in the course of derivatives and the benefit that they provide - the fertilizer, so to speak - and there’s no doubt that that’s the case. But most modern financial derivatives have been highly leveraged, and it’s that leverage that has rather stealthily snuck in to the economy. And when the leverage goes too far, when the spreads get too tight, when the prices get too high, the de-leveraging is very painful. Especially in the property market, which is, perhaps, the most highly levered asset class of all.

And so, yes, the financial derivatives to the extent that even a subprime is a derivative, or an option-adjusted ARM is a derivative, and then of course, the conduits that include them, all of them levered at five, 10, 15, 20 times - and all with the assumption that things can’t go wrong, and that the only task is to scrape off the carry and the return off the top - you know, that concept is, basically a dying concept and will lead to an implosion at the edges, at least, of this new financial marketplace.

FT: So we’re going to see the whole concept of some hedge funds no longer operating?

MR GROSS: A hedge fund basically, makes its money - hopefully, through brilliance, but in reality, through leverage and the ability to borrow short and to lend longer and riskier. That’s what a hedge – hedge fund is basic –

FT: Do you think this has been a giant con? The investors haven’t been smart enough to see through that?

MR GROSS: Well, a hedge fund, to my way of thinking, is an unregulated bank. I mean, a bank isn’t a con, but a bank is a regulated entity. A hedge fund is not, and so from that standpoint it’s been a con on the government, in terms of their unwillingness to regulate the industry. And it’s been a con as well to those investors that have felt that hedge funds could provide double-digit returns forever - or even for a short period of time. That can be done, and was done, but ultimately, you can’t manufacture asset returns simply through the employment of leverage.

FT: And what do you think is the biggest problem facing America today?

MR GROSS: Oh, I think our biggest problem is the enormous future liabilities that we have, and that haven’t even been addressed. We have immediate problems in terms of the housing market, but our future liabilities in terms of healthcare, in terms of social security, in terms of the retirement of the boomers and the aging of the boomers and the ultimate ill health I guess of the boomers - and that’s what happens as people get older - that those liabilities are enormous and they number in the tens of trillions of dollars that haven’t been addressed and ultimately have to be.

They’ll be addressed, in my opinion, with cheaper money, a declining currency and higher interest rates as we go forward. But that’s, perhaps, for another day, not for 2008.

FT: And now, Bill Gross places his bets on Long/Short. Now we’re going to play Long/Short Mr Gross. Are you ready?

MR GROSS: Oooh! Long/Short. I’m ready.

FT: US interest rates?

MR GROSS: Long.

FT: Hillary Clinton?

MR GROSS: Long.

FT: Oil?

MR GROSS: Short.

FT: Manhattan real estate?

MR GROSS: Short.

FT: Hedge funds?

MR GROSS: Short.

FT: Mitt Romney?

MR GROSS: Short.

FT: The euro?

MR GROSS: Short.

FT: Ben Bernanke?

MR GROSS: Long.

FT: Barack Obama?

MR GROSS: Long.

FT: China?

MR GROSS: Long! [laughs]

FT: Thank you very much.

MR GROSS: You’re welcome.