Bill Gross made headlines when he predicted that the subprime mortgage crisis would spread beyond the housing sector and prompt the Federal Reserve to cut interest rates. Gross said the mortgage-sector crisis will impact consumption and new home building over the next year to year-and-a-half. The subprime crisis "may be just what the Fed has been looking for: easy credit becoming less easy, excessive liquidity returning to more rational levels." He predicted that the Fed would reduce the Fed Funds rate over the next six months.

Gross also said that the problems of two Bear Stearns hedge funds are similar to the collapse of Long Term Capital Management. He wrote, "The right places to look for contagion are therefore not in the white-washed Bear Stearns hedge funds, but in the subprime resets to come and the ultimate effect they will have on the prices of homes—the collateral that's so critical in this asset-backed, and therefore interest-sensitive financed-based economy of 2007 and beyond." Gross concluded, "Because while the Bear Stearns hedge funds are now primarily history, those millions and millions of homes are not. They're not going anywhere...except for their mortgages that is. Mortgage payments are going up, up, and up…and so are delinquencies and defaults."

What makes Gross' outlook especially interesting is that Alan Greenspan is now a consultant to Pimco, but Gross didn't mention Greenspan's name or imply that he's influencing his opinions. However, I have to say that I'm pleased that Gross is agreeing with me that the Fed will be forced to cut interest rates later this year.

My argument is based on the fact that the core rate of inflation will continue to decline. On Friday, the Commerce Department reported that core consumer prices based on the personal consumption expenditure (PCE) index rose just 0.1% in May. This is more evidence that core inflation is fizzling and is now up just 1.9% in the past 12 months. Even more important, this is the first time in three years that the core PCE index has risen less than 2%.

As I'm sure that you have heard me say again and again, the core PCE is the Fed's favorite inflation indicator. Under Bernanke, the Fed unofficially targets core inflation between 1% to 2%. When the core PCE falls to 1.6% or less, I expect that the Fed will cut interest rates. On Thursday, before the core PCE was announced, the Fed concluded their meeting and said that they're not yet convinced that inflation has been beaten, but I think the goal is now within sight.