The US Federal Reserve is likely to raise interest rates once in December and again sometime next year as it continues its fight against inflation, according to William Lee, Chief Economist and Managing Director at Global Economic Advisors. Lee believes the rapid expansion of artificial intelligence (AI)-related capital spending, increasingly funded through debt, could create risks for financial markets if borrowing costs remain elevated.
“The focus on AI financing, the financing of the capex, a huge amount of debt that’s being used from the private capital markets, and in the form of private capital, which is very opaque, variable rate, and has very few confidence associated with it, represents a rise in potential systemic risk with this expansion in the capacity,” he said.
The Fed left interest rates unchanged on Wednesday, October 28, holding its benchmark rate at 3.75%-4.0% even as inflation remains above its target. The central bank last raised rates by 25 basis points at its September meeting.
Lee expects interest rates to remain higher as demand for capital continues to grow, particularly because of investments in artificial intelligence. He believes investors will increasingly differentiate between companies with strong cash flows and those relying heavily on debt to finance AI expansion.
He added that policymakers remain focused on containing inflation while keeping an eye on financial stability.
According to Lee, while the Federal Reserve’s latest policy decision was widely expected, the bigger development is the behaviour of long-term interest rates. He said rising government deficits across major economies, coupled with strong borrowing demand linked to AI infrastructure, are pushing long-term yields higher.
Lee pointed to comments from former Federal Reserve Governor Kevin Warsh, who recently highlighted the risks associated with financing AI investments. He said many investors had assumed AI spending was insulated from higher borrowing costs, but recent market movements suggest otherwise.
He warned that the AI investment cycle has expanded beyond large, cash-rich technology companies and is increasingly drawing in firms with weaker balance sheets. Much of this financing is taking place through private credit markets, where transparency is limited.
“The AI trade itself is starting to differentiate across companies. You no longer have Magnificent Seven… It’s going to become a stock pickers market,” Lee said.
Lee cautioned that if companies begin missing debt payments, problems could spread through private credit markets before reaching banks that provide backup funding facilities.
He maintained that higher interest rates are justified because demand for capital remains strong.
“Rates should be higher because that excess demand for capital means that the market’s got to allocate,” Lee said.
However, he added that lower rates would only return if a severe financial downturn triggered widespread defaults, calling that not a good reason for rates to go down.
For the full interview, watch the accompanying video
Fed likely to raise rates again as AI debt boom faces scrutiny, says William Lee
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