Why the Fed does have to worry about the stock market's impact on the economy, according to Goldman Sachs

Goldman Sachs estimates that for every additional 10% drop in the stock market, US GDP growth would be reduced by 45 basis points over the next year.

• Another market plunge could impact US GDP growth and Fed policy, according to Goldman Sachs.
• The bank estimated that a 10% stock market sell-off could reduce US GDP growth by 45 basis points over the next year.
• Further declines in the stock market may prompt the Federal Reserve to cut interest rates to mitigate economic impact.

"The stock market is not the economy" is a common refrain on Wall Street.

However, according to Goldman Sachs, the stock market can, in fact, have a direct impact on the economy, and the Federal Reserve should pay close attention to it.

"Since the July employment report last Friday, the equity market has sold off about 5% and the 10-year Treasury rate has fallen 21bp. Our financial conditions index (FCI) growth impulse model implies that the changes in these and other asset classes will reduce GDP growth over the next year by roughly 12bp on net," economists at Goldman Sachs wrote in a note this week.

While the risk of the recent stock market decline "so far looks limited" for the broader economy, an extended decline in stock prices could negatively impact the economy and influence what the Fed does with interest rates, according to the bank.

Goldman Sachs estimated that for every additional 10% sell-off in the stock market, US GDP growth would be reduced by 45 basis points over the next year.

"If we include the moves in other asset classes that usually accompany equity market selloff when growth fears arise, the total hit is around 85bp," Goldman Sachs said.

With US GDP growth sitting above 2%, it would take a further 20%+ sell-off for the stock market to singlehandedly push the economy into a recession, the bank argued.

The reason a sharp stock market decline can have such a sizable impact on the economy is mostly due to the wealth effect, which suggests consumers will rein in their spending as they see the value of their investment accounts decline sharply, and vice versa when their investment portfolios substantially rise in value.

The potential for a further stock market decline could have an impact on the Fed's monetary policy, according to the bank.

"We suspect that the bar to push the Fed to cut more quickly would be much lower, both because policymakers are likely to err on the side of caution, especially starting from a point where the funds rate is unnecessarily high, and because the current level of financial conditions already assumes that the FOMC will ease policy by more than what was priced in a few days ago," Goldman Sachs said.

Since the surge in stock market volatility on Monday, market commentators like Wharton professor Jeremy Siegel said the Fed should implement an emergency 75 basis point interest rate cut, followed by another 75 basis point interest rate cut in September.

Such sharp interest rate cuts would help consumers with lower costs of debt, and it could unfreeze the housing market.

But with the S&P 500 only down 7% from its record high, Goldman Sachs says that's not a big enough drawdown for the Fed to step in.

"While market stress is noticeably higher than a week ago, our FSI suggests that there are no serious market disruptions to date that would force policymakers to intervene," Goldman Sachs said.