Little by little, the Federal Reserve is preparing markets for the bad news that the genie is out of the bottle – the genie of inflation, that is, bloated by the biggest peacetime deficits and the biggest expansion of the central bank’s balance sheet in history.

Markets fell Wednesday after the Fed released a chart showing the likelihood of modest increases in interest rates some time in 2023, that is, two years from now.

The Fed now admits that inflation will hit 3.5% in 2021, but claims it will fall back to 2.2% in 2022. We wouldn’t count on that.

Buried in the text of the Federal Open Market Committee’s statement today is a tacit acknowledgement that low inflation is gone. In April the FOMC wrote of “inflation running persistently below this longer-run goal” of 2%. Now it’s relegated to the past progressive: “With inflation having run persistently below this longer-run goal …”

This is the first of many shoes to drop. Investors will feel like they are living a floor below a centipede.

The latest bad news about inflation came from import prices, which rose a higher-than-expected 11.3% in the year to May (and rose at a 14% annualized rate during the month). Import prices rise mainly because the dollar’s exchange rate falls, and the dollar exchange rate is falling because the Fed has flooded the market with dollars.

Under the microscope, we observe that monthly changes in the dollar index correlate to future increases in import prices, with a lag of up to twelve months.

That means more import price increases are in the pipeline for the next year.

The biggest impetus to inflation in terms of the US Consumer Price Index will come from housing.

As we’ve emphasized in the past, the government’s gauge of shelter inflation hasn’t begun to take into account the 13% year-on-year increase in home prices. Shelter makes up a third of the CPI, and the impact of the housing bubble will drip, drip, drip into the inflation gauge for the next two years.

The Fed has a story and has to stick to it, but it’s starting to fray at the edges. Prepare for more spikes in US interest rates.