April 30 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke's assertion that interest rates may need to increase to curb inflation is wrong. That's what Goldman Sachs Group Inc., Merrill Lynch & Co. and UBS AG are saying.

While Bernanke warned last month that the odds of worsening inflation have increased, chief economists at the three firms say the worst housing slump in a decade may drive the U.S. economy into a recession and stifle consumer prices. Their chief economists say the Fed will cut its target for overnight loans between banks at least three times this year.

The conflict boils down to opposing views about real estate. Central bank governors found no evidence that the housing market had affected the broader economy, according to notes of their March policy meeting, released April 11. The National Association of Realtors said last week existing home sales fell 8.4 percent in March, the steepest drop since 1989.

Bernanke is missing ``the linkage between residential housing investment and the broader economy,'' Jan Hatzius, chief U.S. economist at New York-based Goldman, the world's most profitable securities firm, said in an interview. ``The housing downturn is of the first order of importance.'' Hatzius says the Fed will cut rates three times this year, to 4.5 percent from 5.25 percent.

That should be bullish for bonds, says David Rosenberg, chief economist at New York-based Merrill, the world's biggest brokerage firm. He expects 10-year Treasuries to produce the best returns since 2002.

`Economic Malaise'

Yields on 10-year Treasury notes have barely budged this year. The yield on the benchmark 4 5/8 percent note due in February 2017 fell 7 basis points, or 0.07 percentage point, today to 4.62 percent.

``The housing-led economic malaise has spread to the business sector,'' said Rosenberg, who anticipates the Fed will cut its target rate four times to 4.25 percent this year, in an interview. ``The economy is still on a slowing trend.''

The U.S. economy grew at a 1.3 percent pace in the first quarter, the slowest in four years, the government said April 27.

``House prices could decline as much as 10 percent,'' said Maury Harris, chief economist at UBS in New York, in an interview. UBS, based in Zurich, is the world's biggest money manager for the wealthy.

Fed research doesn't agree. The central bank reported ``signs of stabilization in housing demand in most regions of the country,'' according to the April 11 report. ``Home-buying attitudes improved and continuing job growth could be expected to support home sales.''

Job Growth

The economy added 180,000 jobs in March, 50,000 more than the consensus of economists in a Bloomberg survey, the Labor Department said on April 6.

The Fed's preferred measure of inflation, the Commerce Department's price index for consumer spending on items excluding food and energy rose 0.3 percent in February, exceeding the 0.2 percent median forecast of economists surveyed by Bloomberg News. The price gauge rose 2.3 percent from a year earlier, higher than the Fed's comfort level of 1 percent to 2 percent.

``Recent readings on inflation and productivity growth, along with higher energy prices, had increased the odds that inflation would fail to moderate as expected,'' the Fed minutes showed. That's the ``predominant concern,'' for policy makers, according to the report.

The meeting minutes gave no hint of a rate cut and said ``further policy firming might prove necessary to foster lower inflation.''

Out of Time

Even if the economists are right about the direction of interest rates, they're running out of time for the predictions to come true. Fed policy makers have six scheduled rate meetings left this year.

``There's a little bit of wishful thinking,'' said Susan M. Phillips, dean of the George Washington University School of Business in Washington and a governor of the Federal Reserve Board from 1991 through 1998. Fed officials have said ``they'll be looking at what the data indicates,'' and since the last meeting of policy makers, ``energy prices have taken a hike,'' she said in an interview.

Crude oil jumped to the highest in almost eight months last week, and gasoline rose after Saudi Arabian authorities said they arrested more than 170 people suspected of plotting to attack the nation's petroleum fields.

Options traders are reducing bets the Fed will cut rates. The odds of borrowing costs falling to 4.5 percent are about 1 percent, according to options on fed fund futures. A month ago, traders saw an 18 percent chance that rates would fall that low.

The Marketplace

``Nobody in his right mind thinks the Fed will ease three times,'' said Stan Jonas, who trades interest-rate options in New York at Axiom Management Partners LLC, in an interview. ``The marketplace is not saying that at all.''

Goldman, Merrill and UBS are among seven of the 21 so-called primary dealers, who trade directly with the Fed, forecasting that the central bank will cut its target rate from 5.25 percent to as low as 4 percent.

They failed to anticipate the Fed in the past. Goldman projected an increase in June 2002 and the central bank ended up cutting rates the next quarter. UBS expected the Fed to double its target by the end of 2003 to 2.5 percent from 1.25 percent. Instead, the Fed reduced borrowing costs to 1 percent in June 2003.

Merrill had forecast in early 2006 that the Fed would end a series of increases when its benchmark reached 4.5 percent. Instead, the Fed boosted rates to 5.25 percent in June.

Pessimistic Picture

``Forecasting an administered rate that's set around a mahogany table is no easy task,'' said Merrill's Rosenberg. ``It's not the same as forecasting a market rate.''

The Fed has ``backtracked'' on the more bullish elements of its forecasts, Rosenberg said. ``They've cut their forecast on capital expenditures and they've extended the timing of the housing recovery.''

The Fed's so-called Beige Book released April 25, which compiles observations and forecasts from 12 regional banks, offered a more pessimistic picture of the economy than previous pronouncements, he said. Rate cuts have not been forthcoming because ``the Fed is handcuffed right now by the lack of any slackening in the labor market.''

``They're not telling us they're not going to change their mind,'' Goldman's Hatzius said. ``Everybody would prefer it if every forecast was right. At the moment we're probably perceived as more right than wrong.''

To contact the reporter on this story: Daniel Kruger in New York at dkruger1@bloomberg.net.

Last Updated: April 30, 2007 15:26 EDT