With rates unchanged in August, the question becomes: when will they fall?

Market expectations for interest rates have shifted rapidly over the past six weeks, with many tipping the RBA to hike rates as recently as two weeks ago.

But expectations are now that the next move from the RBA will be down, to the relief of mortgage holders. So when might rates fall?

What is the RBA trying to do?

The RBA is an inflation-targeting central bank. This means they adjust interest rates to encourage or slow economic activity and keep inflation low and stable. Their stated target is to keep inflation between 2% and 3% over the longer run.

So they watch inflation closely, and dedicate a lot of time to forecasting future inflation. However, inflation has been too high for some time now.

While the RBA has raised interest rates to slow the economy, they have been tolerating above-target inflation to achieve a ‘soft lending’ for the economy. That's a landing that lowers inflation while preserving the strong job creation that we have had over the past few years.

It comes as the unemployment rate fell as low as 3.5%, levels not seen since the 1970s, and has since increased to a still very-low 4.1%.

RBA governor Michele Bullock kept interest rates on hold on Tuesday. Picture: NCA NewsWire / Martin Ollman

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Inflation measures have given mixed signals

In late June, when the monthly version of the Consumer Price Inflation (CPI) showed an increase in annual inflation, many tipped the RBA would have to deliver more interest rate pain in August to get inflation back to their target in a reasonable time frame.

But the monthly CPI is less comprehensive than the long-running quarterly version.

When the June quarterly inflation numbers were released on the last day of July, they confirmed inflation running almost exactly in-line with the RBA’s May forecasts.

In response, interest rate expectations have reversed

These inflation releases understandably had a big impact on expectations for interest rates.

Following the reacceleration in inflation in the May CPI, market expectations (measured through the pricing of financial contracts on the future cash rate, which the RBA controls) expected a solid chance of a rate rise this week, with rates expected to be unchanged through into late next year.

But the most recent quarterly CPI data put almost all rate rise fears to bed, and markets shifted quickly to pricing in a full rate cut by February next year and two full cuts by the middle of next year.

Major bank economists from Westpac and Commonwealth Bank expect a rate cut even sooner – in November this year.

That will be welcome news to mortgage holders struggling through the highest interest rates since late 2011.

Why would the RBA lower rates before inflation is back to target?

While inflation is evolving in-line with the RBA’s expectations, they still don’t expect inflation to be back within their target range of 2% to 3% until the last quarter of next year. So why would they lower rates up to a year before that?

It comes back to the soft landing the RBA is trying to pull off. If rates stay too high for too long, the weak momentum of the economy could push inflation quickly down through to the other side of the target. And importantly, unemployment would shoot up, causing economic pain for many. This would be a ‘hard’ landing.

The RBA wants to lower rates slowly as inflation adjusts downwards, so it settles nicely in the middle of the target band.

But as we have seen, inflation is by no means guaranteed to progress as the RBA expects, and there are many possibilities from here.

As it stands, however, mortgage holders may be in for relief in just a few short months. Many will have their fingers crossed.