Data on Tuesday showed WPI rose a lower-than-expected 6.87 percent last month, coming in below expectations as food and fuel inflation cooled. However, a pick-up in manufacturing price pressures pushed core inflation to around 5.44 percent from 4.9 percent in June.
That adds a wrinkle to bond market expectations for rate cuts at the Reserve Bank of India's policy review in mid-September, as the data still remains above the central bank's expected comfort levels.
The central bank governor Duvvuri Subbarao has consistently maintained his hawkish stance on inflation, but that has been at odds with recently appointed Finance Minister P. Chidambaram who last week warned high interest rates were burdening consumers.
"This data cannot be taken as evidence that inflation is coming down," said A. Prasanna, an economist at ICICI Primary Dealership in Mumbai.
"There are underlying risks. Crude prices have gone up, core inflation is higher, so this fall in inflation may be temporary," Prasanna said.
India's benchmark 10-year bond yield rose 2 basis points to 8.22 percent from its previous close in volatile trade. It traded in the range of 8.12 to 8.24 percent in the day.
The country's one-year overnight index swap rate was 3 bp higher at 7.78 percent and the five-year rate was 4 bp higher at 7.09 percent on the session from the previous day.
India's economy is growing at its slowest in almost a decade, as shown by the unexpected fall in June industrial output last week and by the slump in exports in preliminary trade data issued on Tuesday.
However, inflation remains well above the RBI's comfort level, believed to be at around 5 percent for headline WPI. After cutting interest rates by an aggressive 50 bps in April, the central bank has since kept policy on hold, disappointing investors who had expected more aggressive action.
Subbarao on Monday maintained a hawkish tone, and prodded the government to restrain its own borrowing.
Weaker-than-expected rainfalls so far in the monsoon season have also raised concerns about a hike in food prices which could add to inflation woes.
"The September rate decision will likely be a judgment call by the central bank on whether they want to show confidence in the new finance minister and support growth, or stick to the tougher line," said Dariusz Kowalczyk, senior economist for Credit Agricole in Hong Kong.
"Weak industrial output and very poor exports suggest that there is rate cut scope, but we need to see how the monsoon develops and what the outlook will be for food prices by then."