The consumer price index, which measures price increases at the retail level, rose 0.4 percent in July, slightly higher than June's 0.2 percent increase. But with food and fuel prices removed, so-called "core" CPI rose just 0.2 percent, less than the 0.3 percent economists expected.

Combined with yesterday's producer price index, which showed a decline in core wholesale prices, the data point to a drop in inflation pressures. That would allow the Fed to stop raising rates, which would otherwise threaten economic growth and cramp corporate profits.

"The Fed could not have written these numbers any better to make their case on the economy," said Jack Ablin, chief investment officer at Harris Private Bank. "This, I think, could really help the markets start to move forward."

The Dow rose 96.86, or 0.86 percent, to 11,327.12, its best close since May 16. The Dow has gone up nearly 229 points in two days.

Broader stock indicators also advanced. The Standard & Poor's 500 index added 9.85, or 0.77 percent, to 1,295.43, its highest level since May 11, and the Nasdaq composite index gained 34.53, or 1.63 percent, to 2,149.54 for its best close since July 6.

Bonds gained on the good inflation news, with the yield on the benchmark falling to 4.87 percent from 4.93 percent late yesterday. The dollar lost ground against other major currencies, while gold prices rose.

Crude oil futures slipped for the second straight session as tensions in the Middle East continued to cool. A barrel of light crude settled at $71.89, down $1.16, on the New York Mercantile Exchange.

The housing market showed more signs of slowing, which could also motivate the Fed to maintain its current position on rates. Housing starts fell to an annualized rate of 1.795 million in July, down from 1.85 million in June. The number of building permits issued likewise fell.

The slowing economy and steady prices are good for stocks, but traders are watching closely to see whether the rally has staying power. Quincy Krosby, chief investment strategist for The Hartford, said the S&P 500's inability this summer to stay above the 1,280 level — a key number for market strategists — has shown some remaining hesitance by investors.

"If we can see the market hold here and then build out, then that may be the beginning of a longer rally," Krosby said. "It really depends on whether this slowing economy affects earnings or not, and we'll have to wait and see for that."

In earnings news, cosmetics maker Estee Lauder Cos. Inc. saw its fiscal fourth-quarter profits slid 33 percent on one-time charges related to cost cutting and a tax settlement, but the company nonetheless beat Wall Street profit forecasts by a penny per share. Estee Lauder slid 43 cents to $36.75.

Bulk discount retailer Big Lots Inc. added 73 cents to $18.50 after posting a second-quarter profit versus a year-ago loss and raising its forecasts for full-year profits. Analysts expected the company to post another loss.

Clothing retailer Abercrombie & Fitch Co. said its quarterly profits climb 14 percent on strong sales of its surfer-related clothes. Abercrombie jumped $7.88, or 14 percent, to $63.40 on the news.

Advancing issues outnumbered decliners by more than 3 to 1 on the New York Stock Exchange, where preliminary consolidated volume came to 2.58 billion shares, compared with 2.38 billion traded yesterday.

The Russell 2000 index of smaller companies was up 9.56, or 1.37 percent, at 707.39.

Overseas, Japan's Nikkei stock average surged 1.61 percent. In Europe, Britain's FTSE 100 closed down 0.02 percent, France's CAC-40 rose 0.44 percent for the session and Germany's DAX index gained 0.63 percent.