Dec. 12 (Bloomberg) -- The three most accurate forecasters of U.S. interest rates say the Federal Reserve will need to lower borrowing costs below 4 percent to prevent credit markets from seizing up.

UBS AG, Deutsche Bank AG and Dresdner Kleinwort were the only primary dealers of U.S. government securities to correctly forecast a year ago that the central bank would reduce its target rate for overnight loans between banks to 4.25 percent, according to a Bloomberg survey. The median estimate of the 22 firms was for a decline to 4.75 percent.

The economists now say policy makers will cut the target by at least another half percentage point because banks are raising costs for loans amid mounting losses from securities tied to subprime mortgages. The difference between the interest banks and the government pay for three-month loans, called the TED spread, rose to 2.21 percentage points yesterday from 1.59 percentage points on Sept. 18 when the Fed began lowering rates.

``The financial impact from subprime started off the chain reaction,'' said Maury Harris, chief U.S. economist in New York for UBS, Europe's biggest bank by assets. ``The decline in home prices was the genesis of everything that's happened,'' Harris said in a telephone interview. ``The economic impact is showing up now.''

A New Plan

The Fed cut its target rate by a quarter percentage point to 4.25 percent yesterday, and reduced the discount rate charged for direct loans by the same amount to 4.75 percent. ``Recent developments, including the deterioration in financial market conditions, have increased the uncertainty surrounding the outlook for economic growth and inflation,'' the central bank said in a statement.

The Fed followed that move today by announcing a joint effort with the European Central Bank and three other central banks to alleviate the global credit squeeze. The measures sent Treasuries to their biggest decline in 11 years, reversing a rally yesterday. The plan includes four auctions by the Fed that will add as much as $40 billion to the U.S. banking system.

Bonds rose the most in three years yesterday on concerns from traders that the Fed would do too little to avert a recession or calm the sudden increase in borrowing costs that started when losses from mortgages to people with poor or risky credit contaminated credit markets in July. The market for commercial paper backed by assets such as mortgages and credit- card payments, fell by more than 30 percent since August to $801.2 billion in the week of Dec. 5, according to data compiled by the Fed.

`Behind The Curve'

Policy makers will likely reduce their key rate to 3.5 percent by July, said Harris, 60, whose team was ranked as the best on Wall Street in Institutional Investor magazine's annual survey in September. Zurich-based UBS is the biggest money manager for wealthy investors.

``The Fed got further behind the curve,'' said Joseph LaVorgna, the chief U.S. economist at Deutsche Bank's securities unit in New York. ``The market is now going to test the Fed,'' said LaVorgna, 39, who expects the fed funds rate to drop to 3.75 percent by April. Frankfurt-based Deutsche Bank is Germany's biggest bank.

`Half-Way Through'

Two-year note yields rose more than a quarter of a percentage point to 3.21 percent at 10:39 a.m. in New York, according to bond broker Cantor Fitzgerald LP. The price of the benchmark 3 1/8 percent note due in November 2009 fell 18/32, or $5.63 per $1,000 face amount, to 99 27/32.

``A housing contraction is not something that's short- lived,'' said Kevin Logan, 58, the chief U.S. market economist in New York at Dresdner, a unit of Munich-based insurer Allianz SE. ``Maybe we're half-way through,'' he said in a telephone interview.

Logan forecasts rates will drop to 3.75 percent by July.

Home prices in the 20 biggest U.S. cities dropped 4.5 percent in the third quarter from a year earlier, the most since records began in 1988, according to a Nov. 27 report by S&P/Case- Shiller. That followed a 3.3 percent decline in the second quarter.

The number of Americans who fell behind on their mortgage payments rose to a 20-year high of 5.59 percent in the third quarter as borrowers failed to refinance or sell their homes, the Mortgage Bankers Association said last week in Washington. Foreclosures hit an all-time high.

`Financial Crisis'

While the Deutsche Bank, Dresdner and UBS economists correctly predicted the housing slump would force the Fed to lower borrowing costs, none said the reductions would largely be in response to a reduction in short-term credit.

Economists predict the economy will avoid a recession. The median estimate in a survey of 63 economists is for the economy to expand 1 percent this quarter and 2.2 percent in 2008.

Economic growth will be ``very weak fourth quarter and below-trend in the first quarter,'' LaVorgna said in a phone interview. ``It has taken a financial crisis to get the easing that was consistent with where the growth was.''

To contact the reporters on this story: Daniel Kruger in New York at dkruger1@bloomberg.net; Steve Matthews in Atlanta at smatthews@bloomberg.net.

Last Updated: December 12, 2007 10:57 EST