Gross says Fed should not cut funds rate to 1 pct

NEW YORK (Reuters) - The Federal Reserve should not cut its benchmark interest rate as low as 1 percent because of the inflation risks and danger of weakening the dollar, the manager of the world's biggest bond fund said on Tuesday.

Economists expect the fed funds target rate, now at 3.5 percent, will bottom at around 2.5 percent in the current monetary easing cycle, according to a Reuters poll on Monday.

Fed Chairman Ben Bernanke "must recognize the reduced benefits and obvious dangers of a deja vu trek to 1 percent short rates," wrote Bill Gross, chief investment officer of bond fund management company PIMCO or Pacific Investment Management Co. in a February Investment Outlook.

Gross manages the PIMCO Total Return Fund, the world's biggest bond fund.

Such deep cuts in the funds rate now would likely cause "bubble creating, inflation inducing damage to the U.S. dollar," Gross wrote.

The Federal Reserve slashed the funds rate by 75 basis points in an emergency rate cut on January 22 to the current 3.50 percent. Market analysts expect the Fed to cut that rate again when its scheduled monetary policy setting meeting ends on Wednesday.

The Fed last cut the funds rate to 1 percent in June 2003, sending Treasury yields to their lowest in four decades and helping to accelerate a housing market boom with cheap mortgages.

But cutting the funds rate so low again would not fix weakness in the U.S. economy, as house prices slide and activity ebbs, Gross argued.

"An artificially low, 1 percent short-term interest rate was an elixir during the days of a burgeoning shadow banking system. It cannot be the solution now," he wrote.

To keep mortgage rates low, Gross favors reform rather than very aggressive rate cuts.

"Best to stop far short of 1 percent and at the same time encourage reforms in FHA (Federal Housing Administration) government assisted programs that would permit subsidized mortgage rates with minimal down payments," Gross wrote.

But restoring the U.S. and world economies to brisker economic growth will take some time, Gross signaled.

"In late 2008, the U.S. economy and its somewhat coupled global companion will sleep walk for some time and a resumption of prosperity as we knew it will be dependent on reforms of monetary and fiscal policy resembling the 1930s more than our past decade," he wrote.

(Reporting by John Parry and Richard Leong; Editing by Chizu Nomiyama,)