It was the first time such prices have fallen in any month since 1982.
The report on consumer inflation sent a positive signal to investors and borrowers. It suggested that short-term rates can remain low without triggering inflation.
Some have worried that a Fed rate increase affecting consumers and businesses might be imminent, especially after it just raised the rate banks pay for emergency loans.
The news of low inflation eased some concerns and helped support stock prices. In mid-afternoon trading, the Dow Jones industrial average rose about 9 points, or 0.1 percent. Broader stock averages also gained modestly. Bond prices were little changed, and the dollar was mixed against other major currencies.
The Fed has kept a key bank lending rate at a record low near zero since December 2008. The goal is to entice consumers and businesses to boost spending. Most economists don't expect the Fed to raise rates anytime soon.
"Rate hikes remain unlikely until late 2010 or early 2011," Eric Lascelles, an economist at TD Securities, wrote in a research note.
Overall consumer prices edged up 0.2 percent in January, the Labor Department said. But excluding volatile food and energy, prices fell 0.1 percent. That drop, the first monthly decline since December 1982, reflected falling prices for housing, new cars and airline fares.
The news was better than expected, especially after the government said Thursday that inflation at the wholesale level, excluding food and energy, rose 0.3 percent in January.
"After a few reports showing higher inflation trends, we saw proof today that they have yet to trickle down to the consumer level," said Jennifer Lee, the senior economist at BMO Capital Markets. "What price pressures did exist all came from the volatile food and energy categories."
The 0.2 percent rise in overall prices reflected a 2.8 percent jump in energy costs. That's the biggest one-month gain since August. Energy prices were driven by a 4.4 percent rise in gasoline pump prices and a 3.5 percent increase in the cost of natural gas. Food prices rose a moderate 0.2 percent, even though fruit and vegetable costs jumped 1.3 percent.
In raising the rate banks pay for emergency loans, the Fed said Thursday its action should not be seen as a sign that it would soon begin raising a key target for consumer and business loans. Still, global financial markets were roiled by the announcement.