Markets aren't correctly evaluating the Federal Reserve pushing rates toward a "very harmful, very damaging level," according to billionaire investor Ray Dalio, warning investors that a sharp drop in the stock market is looming.

In an interview with Business Today on Wednesday, the Bridgewater founder said inflation may stand at 4.5%-5%, still above the Fed's 2% target, meaning policymakers would have to raise rates to a level approaching 6%.

"The Federal Reserve will put the short-term rate up towards that level, which is very harmful, very damaging to the economy," he said. "But what the Federal Reserve is trying to do is balance those, having an interest rate that's high enough for the creditor, but not so high for the debtor. And so, what you're going to see is a slowing of the pace of the rise, but still approaching over 5%, probably in the vicinity of 5.5%. This will still have an effect on all markets, particularly stocks."

Previously, Dalio estimated rates past 4.5% would trigger a recession and a 20% slump in stocks, in line with predictions from Bank of America, Morgan Stanley, and Deutsche Bank.

"What you see built into the curve today is a fall-off in rates and a fall-off in inflation. But I believe that you'll see it staying higher than those levels that are built into market expectations now," he added. 

That's upping risks for stagflation; something economists have been eyeing as inflation skyrocketed to a 41-year record this summer.

Top economist Mohamed El-Erian warned that the US was already slipping into a stagflation crisis, and "Dr. Doom" economist Nouriel Roubini sounded alarms for an even more severe stagflationary debt crisis. This market crash combines elements of 70s-style stagflation and the 2008 financial crisis.