The Dow Jones Industrial Average, which comprises stocks of 30 large US corporations, closed up 1.6%.
The S&P 500 index, which represents the top 500 US stocks, finished up 2.1%.
The Nasdaq Composite Index, which comprises marquee names in technology such as Amazon, Apple, Netflix and Google, settled up 2.9%.
Stocks rallied after the US Labor Department reported that the Consumer Price Index (CPI) rose by 8.5% during the year to July versus a 9.1% annual expansion in June that marked the biggest inflation spike in 41 years.
Economists polled by US media had expected an annual growth of 8.7% for July's CPI. For the month, they forecast a 1.3% expansion while the Labor Department reported zero growth.
“This was a welcomed inflation report as every metric came in below consensus estimates,” Ed Moya, analyst at online trading platform OANDA, said.
Money market traders immediately priced in a higher probability for a 50-basis point, or half percentage point, hike at the Federal Reserve’s next rate revision meeting on Sept. 21. Prior to this, bets had been heavy for a 75-basis point, or three quarter percentage point, increase.
The July CPI number was the first appreciable retreat in inflation although the drop itself was just about 0.6% on the year.
After four rate increases since March that brought interest rates from nearly zero to as high as 2.5%, the Fed had been bewildered for months to witness inflation barely budging from four-decade highs. The US central bank’s target for inflation is a 2% per year, or four-and-a-half times less than the June CPI high of 9.1%.
The CPI report will be one of the many data points that will be perused by the Fed over the next six to seven weeks as it determines how to proceed with an economy that has slipped into the technical definition of a recession from two straight quarters of negative gross domestic product growth.
The CPI report aside, the Producer Price Index figures for July will be released on Thursday, along with the weekly report on initial jobless claims, while the University of Michigan consumer sentiment index will be published on Friday. These smaller data points could also help navigate the Fed in its decision-making on interest rates.