While fuel and food inflation cooled, a pick up in manufacturing price pressures pushed core inflation up to around 5.44 percent from 4.9 percent in June, economists estimated.
Analysts had forecast the wholesale price index (WPI) -- India's benchmark inflation gauge -- would rise 7.37 percent in July from a year earlier to pick up from June's increase of 7.25 percent.
Inflation had stayed above 7 percent for two-and-half-years, restraining the Reserve Bank of India from easing monetary policy too aggressively despite the steepest slide in economic growth in almost a decade in the January-March quarter.
"This data cannot be taken as evidence that inflation is coming down," said A Prasanna, an economist at ICICI Primary Dealership Ltd in Mumbai.
"There are underlying risks. Crude prices have gone up, core inflation is higher, so this fall in inflation may be temporary. We still think it will be premature for the Reserve Bank of India to cut rates."
India's 10-year government bond yield dropped 8 basis points to 8.15 percent after the data, while India's main stock index swung higher. One-year and five-year swaps rates dropped.
The central bank left its policy rate on hold at 8.00 percent at its last review on July 31, saying that to cut rates would "aggravate inflationary impulses without necessarily stimulating growth."
On Monday, Governor Duvvuri Subbarao maintained a hawkish tone, saying that inflation around 7.3 percent is "above our tolerance level."
The pull back in headline inflation may suggest an easing of price pressures, but the pick up in core inflation may still worry Subbarao.
On July 31 he said that the rising momentum in core inflation was "disturbing".
The central bank has been trying to apply pressure to the government to do more to help revive the economy's fortunes.
Palaniappan Chidambaram, who took up his third stint as finance minister on July 31, promised to unplug supply bottlenecks and arrest a widening fiscal deficit to encourage the central bank to cut rates.
The latest data showed that food prices rose just over 10 percent in July from a year earlier, easing from the 10.81 percent pace seen in June's data.
But fuel inflation fell dramatically to 5.98 percent in July, its lowest level since December 2009, from 10.27 percent in June.
Manufacturing inflation rose to 5.58 percent in June from 5.00 percent in June.
India's interest rates are among the highest among major emerging economies but the rapid descent in growth has prompted calls for the central bank to cut them at its next policy meeting on September 17.
GDP rose just 5.3 percent in the January-March quarter from a year earlier, the weakest pace in nine years, and data since has suggested activity in the April-June quarter remained sluggish. Industrial output fell in June from a year earlier for the third time in four months.
Copyright Thomson Reuters 2012