Contrary to a lot of expectations, the government’s first Budget hasn’t caused massive inflation – at least, not yet. And the Lloyds Banking Group (LSE:LLOY) share price surged on Wednesday (15 January) as a result. 

Shares in the UK’s largest consumer bank jumped 6.3% on news that the rate of price increases in December was lower than people were expecting. But how should investors react to this?

Inflation and interest rates

The latest inflation data from the Office for National Statistics (ONS) showed prices were 2.5% higher in December than the year before. And the FTSE 100 climbed on the news. 

Lloyds was one of the biggest beneficiaries. But lower inflation increases the chances of interest rates coming down at the Bank of England’s next meeting in February.

This isn’t necessarily a good thing for banks in general – or Lloyds in particular. When rates are lower, the margins banks earn on their loans tend to contract, weighing on returns. 

Inflation however’s worse. And this is why the Lloyds shares price caught such a significant boost from the news that prices aren’t rising at the rate they were 12 months ago. 

What inflation means for Lloyds

Inflation matters for Lloyds in a number of ways. The first issue is with its lending activities, where the return the bank stands earns on its loans goes down in real terms.

Another issue is with deposits. Savers also stand to earn a weaker return on their cash, but this increases the risk of them looking elsewhere for better interest rates to offset this. 

Third, the chance of borrowers defaulting on their debts is higher when prices are rising. Household budgets get more stretched and this makes it much harder for people to make their loan repayments. 

This can also weigh on demand for new loans. Given the effects inflation can have on its core banking operations, it’s probably not a huge surprise to see the stock responding very positively.

What should I do?

Investor sentiment has been all over the place recently when it comes to UK stocks. Cash flowed out of UK equity funds at a record rate before the Budget, but this turned around after the announcement.

Equally, concerns over inflation had been causing concerns. But share prices are rallying again as the latest news from the ONS indicates this isn’t as bad as initially feared.

When I buy stocks, I expect to own them at times when inflation’s high, low, or in between. And I strongly suspect the stock market volatility that’s been causing prices to fluctuate isn’t over yet.

As a result, I think buying shares in Lloyds – or any other company – just because the most recent CPI number was lower than anticipated is very risky. So I’m watching this one from the sidelines.

Nothing to see here…

Lower inflation makes Lloyds more likely to earn a decent return on the loans it makes, so the latest news is undeniably positive for shareholders. But this could turn around quickly.

The next update is due in February and if this isn’t so positive, the effect on the stock market could reverse. So from a long-term perspective, I don’t think this is something to pay much attention to.