U.S. consumer prices were unchanged in July due to a sharp drop in the cost of gasoline, delivering the first notable sign of relief for weary Americans who have watched inflation climb over the past two years.

The consumer price index (CPI) was flat last month after advancing 1.3 percent in June, the U.S. Labor Department said on Wednesday in a closely watched report that nevertheless showed that underlying inflation pressures remain elevated as the Federal Reserve mulls whether to embrace another super-sized interest rate hike in September.

The reading was the largest month-on-month deceleration of price increases since 1973 and followed on the heels of a roughly 20-percent drop in the cost of gasoline since mid-June. Prices at the pump spiked in the first half of this year due to the Ukraine crisis, hitting a record-high average of more than $5 per gallon on June 14, according to motorist advocacy group AAA.

Economists polled by Reuters had forecast a 0.2 percent rise in the monthly CPI in July. The Fed has indicated that several monthly declines in CPI growth would be needed before it lets up on the aggressive monetary policy tightening it has delivered to tame inflation currently running at a four-decade high and bring it down to its 2 percent goal.

The lower-than-expected CPI data ignited a strong rally in equity markets, with the S&P 500 index up about 2 percent in early afternoon trading. Investors immediately pared bets the Fed would deliver a third straight 75-basis-point rate hike at its September 20th-21st meeting, instead seeing the U.S. central bank likely to opt for a half-percentage-point hike.

"This is not yet the meaningful decline in inflation the Fed is looking for. But it's a start and we expect to see broader signs of easing price pressures over the next few months," said Paul Ashworth, chief U.S. economist at Capital Economics.

U.S. consumer prices have been surging due to a number of factors, including snarled global supply chains, massive government stimulus early in the COVID-19 pandemic and the Russia-Ukraine conflict.

Food is one component of the CPI that remained elevated in July, rising 1.1 percent after climbing 1 percent in June.

The price of gasoline fell 7.7 percent in July.

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In the 12 months through July, the CPI increased by a weaker-than-expected 8.5 percent following a 9.1 percent rise in June. Underlying inflation pressures, which exclude volatile food and energy components, also showed some green shoots despite remaining strong.

The so-called core CPI rose 0.3 percent in July, a 10-month low, after climbing 0.7 percent in June, helped by an almost 8-percent fall in the cost of airline fares, but still increased 5.9 percent in the 12 months through July, matching the pace in June.

Inflation in the cost of rent and owners' equivalent rent of primary residence, which is what a homeowner would receive from renting a home, rose at almost the same pace as in June. Shelter costs comprise about 40 percent of the core CPI measure.

(Source: Reuters with edits)