May 4 (Bloomberg) -- Warren Buffett, the world's second- richest man, and Bill Gross, the biggest bond manager, lead a small but growing number of investors who say the Federal Reserve should already have raised overnight lending rates to nip inflation before it gets out of hand.

The central bank, which meets today, cut the federal funds rate to a 45-year low of 1 percent in June, citing concern about slumping prices and a slack job market. The economy then grew at its fastest pace since 1984 in last year's second half and economists say it will rise by at least 4 percent a quarter this year, continuing its most rapid growth in two decades.

Fed Chairman Alan Greenspan has ``perhaps been a little slow in terms of moving up because the economy has heated up considerably,'' Buffett, chairman of Berkshire Hathaway Inc., said in an interview Saturday.

``They never should have lowered it to this emergency/deflation prevention level,'' Gross, who runs the world's largest bond fund for Pacific Investment Management Co., said in an e-mail yesterday. The Fed should lift its benchmark rate to 2.5 percent and ``they should get there quick and not with baby steps.''

No Change

Buffett and Gross are likely to be disappointed today. All 96 economists surveyed by Bloomberg News forecast no change in the overnight bank lending rate. The Fed's Open Market Committee probably will signal an increase is likely sometime this year by dropping language, used after its last meeting in March, that said it will be ``patient'' in raising rates.

The central bankers begin meeting at 9 a.m. Washington time, and a decision on rates is expected at about 2:15 p.m.

Since the policy makers last met, government reports have shown the economy created 308,000 jobs in March, the most in four years, while inflation excluding food and energy rose 0.4 percent, the biggest increase in two years. An inflation measure used to adjust first-quarter gross domestic product showed prices expanded at a 2.5 percent annual rate, from 1.5 percent in the fourth quarter.

``Inflation has reared its ugly head once again,'' said Charles Plosser, a professor of economics at the University of Rochester and co-chair of the Shadow Open Market Committee, a group of economists that monitors Fed policy. ``We believe the federal funds target should be raised and raised immediately.''

Fed's View

The 10-year U.S. Treasury note has dropped for six straight weeks on concerns about inflation, which erodes the value of fixed-income investments. The yield on the U.S. Treasury's 4 percent note due in February 2014 was 4.50 percent yesterday, holding near the highest level since September and up from 3.65 percent in mid-March.

``I was a 30-year bond trader for most of my life and I think I would be short if I were operating in the markets,'' said Senator Jon Corzine, a New Jersey Democrat, in an interview with Bloomberg News last Friday.

Recent editorials in The New York Times and The Wall Street Journal have called on the central bank to raise interest rates. Fed officials have defended their policy, saying a month's data doesn't confirm a trend.

``The protracted period of monetary accommodation has not fostered an environment in which broad-based inflation pressures appear to be building,'' Greenspan told the Joint Economic Committee of Congress on April 21.

Getting It Right

The Fed's credibility as an inflation fighter is still high among most investors, said Dominic Konstam, head of interest rate research at Credit Suisse First Boston.

Most of the ``inflation trades'' in asset markets are being ``unraveled,'' Konstam said. In public speeches, Fed officials have ``shifted gears in terms of not committing to keeping interest rates low for a long period of time,'' he said.

For the Fed, ``managing expectations is very critical,'' said Frederic Mishkin, an economist at Columbia University and former research director at the New York Fed.

``I would say if long-term bond yields do not rise above 6 percent'' in the coming cycle of rate increases ``that is an indication that the Fed got it right,'' Mishkin said. ``If you saw monetary policy tighten effectively, the yield curve would decrease'' with differentials on two-year and 10-year notes narrowing, Mishkin said.

Traders describe this as a yield curve that ``flattens,'' and that is what implied forward rates, or Treasury market trader's projections, of show.

Housing Impact

Implied forward rates show the yield spread between two-year and 10-year U.S. Treasury notes narrowing to 1.40 percentage points two years from now from 2.20 percentage points today. Traders expect 10-year note yields to rise 0.54 percentage points while two-year yields climb 2.10 percentage points as the Fed raises interest rates over that period.

``The market believes there will be rate increases and that it will not take much'' to keep inflation low, said Karl Haeling, vice president and head of U.S. debt distribution at Landesbank Baden-Wuerttemburg, Germany's sixth-largest bank.

Maintaining low inflation is critical to the functioning of the economy, especially those sectors most sensitive to long-term interest rates.

Low mortgage rates have kept home sales strong. Sales of previously owned houses rose 5.7 percent in March to 6.48 million houses at an annual rate, the second-fastest pace on record. Sales have been 6 million or higher for nine months, including a record 6.68 million in September. New home sales rose 8.9 percent to a record 1.228 million annual rate in March.

Refinancing Trend

Residential real estate activity accounted for 15.3 percent of gross domestic product last year. Fed officials have embraced the boom in home prices, sales and mortgage refinance as an important source of consumer wealth and positive sentiment.

``Housing markets stayed strong, interest-sensitive sectors stayed strong, and allowed the consumer to bring us through 2003,'' Kansas City Fed President Thomas Hoenig said on April 22.

Homeowners converted $139 billion of home equity into cash last year, and should take another $114.1 billion this year, says Freddie Mac, a company owned by private shareholders and created by the government in 1970 to expand the mortgage market.

The Fed estimates about half of these so-called cash-outs are spent on goods and services.

Freddie Mac chief economist Frank Nothaft forecasts 7.27 million homes will be sold this year versus last year's record of 7.19 million. The 30-year fixed mortgage rate should average 5.8 percent this year, the same as last year, he said.

``It is going to be an excellent year'' for housing, Nothaft said in an interview in the company's headquarters in McLean, Virginia, last week.

Refinancing is expected to slow to 46 percent of all mortgage applications by the end of the year from around 58 percent currently, Freddie Mac said. The average 30-year fixed mortgage rose to 6.01 percent last week, the sixth straight increase and the highest this year.

Each 0.50 percentage point increase in mortgage rates, reduces total home sales by about 2 percentage points, according to Amy Crews Cutts, deputy chief economist at Freddie Mac.

``Monetary policy is now in a transition phase,'' Fed Governor Ben Bernanke said on April 23. ``That short-term interest rates must eventually be normalized is a given.''

To contact the reporter on this story: Craig Torres in Washington at ctorres3@bloomberg.net.

Last Updated: May 4, 2004 00:07 EDT