The Federal Reserve held interest rates steady on Wednesday but signaled that rates could fall in the coming months if inflation continues to cool.

Policy makers have kept their benchmark interest rate between 5.25% to 5.5% — the highest in over two decades — since July.

In its post-meeting policy statement, the Fed's rate-setting committee replaced a reference to possible future rate hikes with a more neutral reference to "adjustments" in interest rates.

Still, policymakers added a note of caution.

"The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2%," the policy statement said.

The Fed has been pleasantly surprised by the rapid drop in inflation in recent months.

Core prices in December — which exclude food and energy prices — were up just 2.9% from a year ago, according to the Fed's preferred inflation yardstick. That's a smaller increase than the 3.2% core inflation rate that Fed officials had projected in December.

If that positive trend continues, the Fed may be able to start cutting interest rates as early as this spring. As of Wednesday morning, investors thought the likelihood of a rate cut at the next Fed meeting in March was about 60%, while the odds of rate cut by May were better than 90%.

Fed policymakers have cautioned, however, that the economy has moved in unexpected directions in recent years, so the central bank is keeping its options open.

"The pandemic has thrown curve balls repeatedly," said Raphael Bostic, president of the Federal Reserve Bank of Atlanta at a meeting of that city's Rotary Club this month. "I'm not comfortable even contemplating declaring victory."

Good omens in the economy

Both the economy and the job market have performed better than expected over the last year, despite the highest interest rates since 2001. The nation's gross domestic product grew 3.1% in 2023, while employers added 2.7 million jobs

Unemployment has been under 4% for nearly two years. And average wages in December were up 4.1% from a year ago.

While that strong economy is welcome news for businesses and workers, it also raises the risk of reigniting inflation. As a result, Fed policymakers say they'll be cautious not to cut interest rates prematurely.

"We have history on this," Bostic said. "In the '70s, the Fed started removing accommodation too soon. Inflation spiked back up. Then we had to tighten. Inflation came down. Then we removed it again. Inflation went back up. And by the time we were done with that, all Americans could think about was inflation."

The Fed is determined not to repeat that '70s show. At the same time, waiting too long to cut interest rates risks slowing the economy more than necessary to bring inflation under control.

A report from the Labor Department Wednesday showed employers' cost for labor rose more slowly than expected in the final months of last year. Labor costs increased just 0.9% in the fourth quarter. That's a smaller increase than the previous quarter, suggesting labor costs are putting less upward pressure on prices.

Fed officials promised to keep an eye on upcoming economic data and adjust accordingly.