Recent weakness in the value of the dollar has reinforced concerns that interest rates are headed upward.
For several years, the strong dollar has been a major factor in suppressing inflation by holding down prices of imports and enforcing price discipline on domestic competitors and exporters.
The effect was enhanced after several major Asian currencies were sharply devalued during the region's financial crisis.
But in July the dollar dipped in value against the yen and euro. A dollar was equivalent to 115.22 yen last week, versus 120.82 at the beginning of July. The euro was worth $1.07, compared with 97 cents at the start of last month.
Several economists said the recent trend is important to watch as a leading indicator of higher inflation and rising interest rates.
"I think there is something very fundamental going on," said Kenneth T. Mayland, chief economist at KeyCorp in Cleveland.
After a long upward run, the dollar may have peaked in value because the pace of the U.S. economy is now slowing while Europe is poised for even stronger expansion and Japan could finally begin to emerge from its long period of weakness.
"The most consistent factors influencing exchange rates are relative economic growth rates, and we are seeing a shift," said Mr. Mayland. "In the U.S. growth is now moderating, while in Europe the second half of the year is going to be better, maybe quite a lot better, than the first half."
Indeed, the U.S. economy slowed far more than expected in the second quarter, at an estimated annual growth rate of 2.3%, off sharply from 4.3% in the first quarter. The drag from the country's huge trade deficit as well as a moderation in consumer spending were behind the slowdown.
As Mr. Mayland sees it, the new trend in foreign exchange "is not a huge negative for inflation or interest rates yet, but it's one more thing that helps create an upward bias in rates for the rest of this year and perhaps well into next year."
The KeyCorp economist went on to say that "the turnaround in the dollar is not something that will put immediate pressure on prices. That effect will be seen more during the year 2000, but of course the financial markets discount future prospects and react far sooner."
Some think the dollar will strengthen again before too long. "The U.S. is still far more efficient, while Europe and Japan have a lot of restructuring yet to do," said Sung Won Sohn, chief economist at Wells Fargo & Co. in San Francisco.
The strong dollar has been among the special factors that have kept inflation strikingly low in recent years. Others are low energy prices, which have recently moved upward, and remarkable productivity growth, which could now slow along with the economy, Mr. Mayland said.
If those special factors fade, the bill may come due for the sizzling economic growth of the past several years. "I was never a believer in the 'new era' idea that faster economic growth was possible indefinitely without the prospect of inflation," he said.
Another economist raised the possibility that a shift in the dollar's value could have more dramatic ramifications-and possibly with a hint of financial deja vu from a dozen years ago.
"The first challenge Alan Greenspan faced as newly installed Fed chairman in 1987 was rising interest rates driven by the trade deficit through the dollar exchange rate," said Nicholas F. Perna, chief economist at Fleet Financial Group in Boston.
A large trade gap in the mid-1980s set off a decline in the dollar's value and culminated in a surge in interest rates-which in turn helped trigger the October 1987 crash of the stock market, he said.
A repeat of that series of events is "not the most likely outcome," Mr. Perna quickly added. "Alan Greenspan is a master of the soft landing. He has two under his belt, and he is capable of pulling off a third."
But if the dollar "falls out of bed," that could turn things into a hard landing or even a recession, he said. A shift comparable to the 40% slide in the exchange rate that occurred in the mid-'80s could "quickly push up inflation fears and rates."
Increased import prices would probably be matched by domestic producers who have long chafed at their lack of pricing power in the marketplace. "Detroit would love to raise auto prices," Mr. Perna said.
The dynamics of the foreign exchange market make dramatic shifts in currency values possible. "A foreign investor who might otherwise like prospects in the U.S. would stay away from dollars until perceiving a bottom in the market," he said.
Meanwhile, alert bond investors may sense a new inflation climate and quickly demand higher risk premiums. "You could get a significant rise in rates not engineered by the Fed," he said.
Could this string of events happen? "It's a long shot but not beyond the realm of possibility with the trade deficit so large," Mr. Perna said. On the other hand, maintaining Fed control of such trends is Mr. Greenspan's forte.
One thing the Fed could do is raise rates a notch at its policy meeting Aug. 24. That would buy time against a lower dollar exchange rate, he said. Though the central bank would not act solely to counter a weaker dollar, this would probably be one factor under scrutiny by policymakers because of its inflationary potential.
"A rate hike on the 24th is not the easiest case to make, with the economy slowing," Mr. Perna said. "On the other hand, taking a pass might mean a stock market rally and another surge in the economy."
Mr. Sohn of Wells Fargo also said he is expecting a Fed rate hike in August, and Mr. Mayland said the prospect of higher rates is strong.