The Fed will probably cut the federal funds rate from 4.75% to 3.75% within the next six to 12 months, Gross wrote in his monthly outlook.
Newport Beach, Calif.-based Pimco is one of the largest managers of fixed-income assets in the world, with more than $650 billion in assets under management.
Read Gross' outlook.
Policymakers will have to adapt to a "brazen new world" dominated increasingly by supercharged private money that is unresponsive to public policy, Gross wrote. Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson will need to throw out the textbooks that describe a lost world in which banks, which dance to the Fed's tune, are the main force in the financial world, according to Gross.
"The modern financial complex has morphed into something unrecognizable to many astute market veterans and academics," Gross said, referring to a "shadow banking system" of derivatives and the alphabet soup of CDOs, CLOs, ABCPs, CPDOs and SIVs.
Bernanke and Paulson know the world has changed, contrary to CNBC commentator Jim Cramer's now-famous rant that "they know nothing." But their response will be hampered by an "uncomprehending press and public" that demands revenge, and by Republican laissez-faire political orthodoxy.
"They know they are in a pickle, and a sour one at that," Gross said, explaining that if interest rates don't fall enough, Bernanke "risks exacerbating a housing crisis."
However, if Bernanke favors homeowners over corporations, "he risks igniting speculative equity market behavior" and a run on the dollar, according to Gross.
But the Fed and the Treasury will have to deal with Main Street's problems, not Wall Street's, he said.
"The downward path of home prices, however, will dominate Fed policy over the next several years as will the lingering unwind of related financial structures and derivatives that have yet to be discovered by the public, and marked to market by their conduit holders," Gross said.
