• According to Goldman Sachs, a further market collapse could affect US GDP growth and Fed policy.
• The bank estimated that a 10 percent sell-off in equity markets could reduce U.S. GDP growth by 45 basis points next year.
• Further declines in the stock market could prompt the Federal Reserve to cut interest rates to mitigate the economic impact.

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

But according to Goldman Sachsthe stock market can actually 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 stock market has sold off about 5% and the 10-year Treasury yield has fallen 21 basis points. Our growth momentum model based on the Financial Conditions Index (FCI) implies that changes in these and other asset classes will reduce GDP growth by about 12 basis points on net terms next year,” Goldman Sachs economists wrote in a note this week.

While the risk of the recent stock market decline to the overall economy “appears limited so far,” a sustained decline in stock prices could negatively impact the economy and influence the Fed’s interest rate policy, the bank said.

Goldman Sachs estimated that US GDP growth would decline by 45 basis points for every additional 10 percent decline in the stock market next year.

“If we include the moves in other asset classes that typically accompany a sell-off in equity markets when growth fears arise, the total loss is around 85 basis points,” Goldman Sachs said.

Given US GDP growth of over two percent, a further decline of over 20 percent would be necessary for the economy to plunge into recession on the stock market on its own, the bank argued.

The reason a sharp decline in the stock market can have such a large impact on the economy is largely due to the wealth effect, which suggests that consumers will cut back on spending when the value of their investment accounts falls sharply, and vice versa when the value of their investment portfolios rises sharply.

The bank believes the potential for a further decline in stock markets could impact the Fed’s monetary policy.

“We suspect that the hurdle for the Fed to cut interest rates more quickly would be much lower. This is partly because policymakers are more likely to be too cautious, especially when the benchmark interest rate is already unnecessarily high, and partly because the current financial situation already assumes that the FOMC will loosen its monetary policy more than was priced in just a few days ago,” Goldman Sachs said.

Since Monday’s spike in equity market volatility, market commentators such as Wharton professor Jeremy Siegel have said the Fed should cut interest rates by 75 basis points in an emergency, followed by another 75 basis point cut in September.

Such significant interest rate cuts would help consumers by lowering borrowing costs and could revive the real estate market.

However, since the S&P 500 has only lost 7 percent from its record high, Goldman Sachs believes this decline is not large enough for the Fed to intervene.

“Although market stress is noticeably higher than a week ago, our FSI suggests that there have been no serious market disruptions to date that would force policymakers to intervene,” Goldman Sachs said.