NEW YORK, Aug 12 (Reuters) - U.S. consumer prices increased slightly in July, potentially weakening the argument for an interest rate increase from the Federal Reserve next month.

The Consumer Price Index edged up 0.1% last month after dropping 0.4% in June, which was the first decline in six years, the Labor Department's Bureau of Labor Statistics said on Wednesday.

In the 12 months through July, the CPI advanced 3.4% after rising 3.5% in June. Excluding the volatile food and energy components, the CPI gained 0.2% last month after being unchanged in June. The so-called core CPI increased 2.5% in the 12 months through July after climbing 2.6% in June.

Economists polled by Reuters had forecast the CPI rebounding 0.1% and core inflation rising 0.2% over the month.

MARKET REACTION:

STOCKS: U.S. stocks opened higher, with the Nasdaq rising 0.9% and the S&P 500 up 0.5%. 

BONDS: Yields declined as investor expectations of a rate hike eased slightly. U.S. two-year yields, which are sensitive to the outlook for interest rate moves, fell 4.2 basis points (bps) to 4.176% . The benchmark 10-year yield slid 3.2 bps to 4.652% .

FOREX: The U.S. dollar index was slightly lower, down 0.1% to 99.66.

RATE BETS: Futures that settle to the Fed's policy rate are pricing about a 55% chance that the central bank will keep the policy rate in its current 3.50%-3.75% range at its September 15-16 meeting, little changed from immediately before the report.

COMMENTS: 

GEORGE BROWN, SENIOR ECONOMIST AT SCHRODERS, LONDON:

"Today's inflation data does little to settle the debate around the Fed's next move. While the labour market appears to have softened, measures of underlying inflation continue to flash red, leaving policymakers with conflicting signals heading into the September meeting.  "Perhaps most importantly, the Fed will be wary not to further sow doubts about its commitment to price stability. Following the recent sell-off in long-term Treasuries, policymakers are likely to place a premium on maintaining confidence that inflation will ultimately be brought under control.  "Hawkish rhetoric can only do so much, with actions speaking louder than words. We continue to believe the direction of travel rates remains higher, even if the timing of the first hike remains unclear."  

ROBERT PAVLIK, SENIOR PORTFOLIO MANAGER, DAKOTA WEALTH, FAIRFIELD, CONNECTICUT:

"The numbers came in right in line. The market's reaction is slightly positive because the market was fearful it was going to come in worse than it did. You're seeing a market thinking that the Fed is not being pushed toward a rate hike. This adds on to Friday's nonfarm payrolls report and it relieves some of the concerns that the Fed is being pushed toward a rate hike due to inflation, which is being fueled by higher energy prices."

LINDSAY ROSNER, HEAD OF MULTI SECTOR FIXED INCOME INVESTING, GOLDMAN SACHS ASSET MANAGEMENT, NEW YORK:

"One down, one to go. With another round of inflation data due before the September FOMC meeting, it remains all to play for, but today's in-line report was a good start. Contained core inflation adds to the encouraging signs in last month's release of a moderation in underlying inflation, helping strengthen the case for a September hold."

CHRISTOPHER HODGE, CHIEF US ECONOMIST, NATIXIS, NEW YORK:

"Slowly but surely the disinflationary path continues, with a third straight encouraging core CPI print. The three-month annualized rate has been lower for four straight months and, as we have argued ad nauseam, broad-based inflationary pressures continue to wane. Given the dismal jobs report that Friday, we argued that the definition for what would be considered an encouraging inflation reading had expanded, and today's number falls into the encouraging category."

GEORGE BORY, CHIEF INVESTMENT STRATEGIST, FIXED INCOME, ALLSPRING GLOBAL INVESTMENTS, LOS ANGELES:

"Today's data shows that we could be past peak inflation. It does take some pressure off the Fed. That being said, it's premature to call the all-clear because some of the underlying inflation figures are still elevated."We expect no rate hikes this year. But as much as the current stats are showing that inflation could be moderating, much hinges on oil prices and the Middle East." 

SAM STOVALL, CHIEF INVESTMENT STRATEGIST, CFRA RESEARCH, NEW YORK:

"We will continue to see little likelihood of the Fed raising interest rates at the September meeting because the inflation data came in as expected. There was no unanticipated increase in inflation.

"Because GDP came in weaker than expected in the most recent reading and the jobs picture also looks weaker, I believe the Fed will remain on hold in September. There is a strong likelihood that it will not raise rates at any point this year.

"First, historically, a brand-new Fed chair's first move has often been to raise interest rates. So, based on history, we should be aware that there could be pressure to raise rates this time around as well. However, the president is likely putting pressure on the Fed chair to pursue lower interest rates. In addition, the data suggest that the economy is vulnerable should the Fed become aggressive in raising rates. That is why we could see a slight rate increase, but likely not the beginning of an aggressive rate-tightening cycle."

BRIAN JACOBSEN, CHIEF ECONOMIC STRATEGIST, ANNEX WEALTH MANAGEMENT, BROOKFIELD, WISCONSIN:

"Inflation isn't flashing code red. It's still not great, but it is trending in the right direction. There are pockets of extreme price pressure, like the 21.2% year-over-year increase in computer software and accessories category, but shelter and insurance inflation is trending lower. There isn't clear evidence that volatile energy prices are feeding into other parts of the consumption basket. An inflation-fatigued consumer is helping cap what costs producers can pass onto consumer."

MARC CHANDLER, CHIEF MARKET STRATEGIST, BANNOCKBURN GLOBAL FOREX, NEW YORK:

"The CPI was in line with expectations. I thought that after the soft jobs data on Friday, that the dollar would stay soft because of the expectations of the soft CPI. The dollar really didn't go anywhere. If anything, it was a bit firmer than I expected. But we are getting a little bit of a weaker dollar after the CPI. It looks like the market may have downgraded very slightly the odds of a September rate hike."

DANIELA HATHORN, SENIOR MARKET ANALYST AT CAPITAL.COM:

"For the Federal Reserve, this is a helpful report rather than an all-clear. Inflation is moving in the right direction despite the earlier energy shock, while recent weakness in the labour market gives policymakers even less reason to consider another rate increase in September. However, headline inflation at 3.4% remains comfortably above target and energy prices are still nearly 15% higher than a year ago, so the Fed is unlikely to declare victory yet, especially after Kevin Warsh was adamant to point out his focus on making sure that high inflation does not become detrimental to the U.S. economy."