Goldman Sachs: The current market volatility does not worry the Federal Reserve, there is no need for an emergency rate cut

The recent market has been quite turbulent. Since the release of the July employment report last Friday, the US stock market has fallen by about 5%, and the yield on the 10-year US Treasury bond has dropped by 21 basis points.

Concerns about an economic recession are escalating, and more and more investors are calling on the Federal Reserve to take interest rate cut measures as soon as possible. The possibility of a 25 basis point rate cut within a week has exceeded half.

Inter-meeting rate cuts are extremely rare, referring to temporary interest rate cut measures taken by the Federal Reserve to deal with unexpected economic events outside of scheduled monetary policy meetings. According to statistics, since 1987, the Federal Reserve has implemented emergency rate cuts nine times, with the last emergency rate cut occurring at the beginning of the epidemic. The next interest rate decision is scheduled to be announced on September 18.

Contrary to market sentiment, Goldman Sachs' Chief Economist Jan Hatzius poured cold water on the calls for interest rate cuts. The analysis results from two models show that the current market volatility will not pose a substantial threat to the economy. Therefore, the Federal Reserve does not need to cut interest rates urgently.

The FCI shows that the current tightening of financial markets has little impact on the overall economy

Goldman Sachs used the Financial Conditions Index (FCI) framework to estimate how changes in market conditions affect the economy.

The FCI includes stock prices, short-term and long-term interest rates, credit spreads, and trade-weighted US dollars. It can analyze the interactions between different economic variables. For example, how a decline in stock prices reduces consumer spending through the wealth effect, or how a decrease in interest rates stimulates real estate activity, and so on.

Data shows that starting from August 1, 2024, the FCI tightened by 19 basis points, but this tightening does not have a significant impact on the overall economy. The specific reason is that the easing effect of interest rate cuts offsets some of the tightening effects of stock market selling.

Our FCI growth impulse model indicates that in the first quarter after the policy shock, the GDP growth rate may decrease by 0.8 percentage points, with an average annual decline expected to be 1.2 percentage points.

Changes in financial conditions (such as rising stock prices and falling interest rates) will have a positive impact on economic growth.

However, Goldman Sachs' forecast shows that this positive impact is gradually weakening. It is expected that by the second half of 2024, the driving force will become relatively small, and by 2025, the impact of changes in financial conditions on economic growth may approach zero.

From the starting point of economic health, the large-scale tightening of financial conditions currently observed poses almost no risk.

So, how long will the market sell-off continue to bring greater recession risks, forcing the Federal Reserve to cut interest rates by more than 25 basis points?

Goldman Sachs data shows that for every 10% further sell-off in stocks, the GDP growth for the next year will decrease by about 45 basis points. If the trends of other asset classes are included (these asset classes usually accompany stock market sell-offs when growth concerns arise), the growth impact will increase to 85 basis points.

This means that even if the economy is currently growing at a rate of over 2% (which is usually considered healthy), a significant and sustained decline in the stock market is needed to push the economy into a recession. However, Goldman Sachs also pointed out that although the Federal Reserve officials may indicate the need for stronger signs of economic downturn to cut interest rates, in reality, the Fed may cut rates earlier and by a larger extent than we imagine:

However, we suspect that the threshold for the Fed to cut rates faster will be much lower. This is because policymakers may act cautiously, especially starting from the point where fund rates are unnecessarily high, and also because the current financial conditions assume that the FOMC will ease policy more than expected a few days ago.

Financial Stress Index (FSI) Remains at Normal Levels

Goldman Sachs also used the Financial Stress Index (FSI) to illustrate. FSI consists of 14 different indicators covering various aspects such as the stock market, bond market, and money market. Through a comprehensive analysis of these indicators, it can provide an early warning signal about the overall health of the financial system.

Data shows that since last Thursday, FSI has tightened significantly (+0.4pt to -0.2). Goldman Sachs pointed out that by historical standards, it still remains roughly at normal levels:

So far, most of the tightening policy is due to increased expected volatility in the stock and corporate bond markets. The financing market has tightened somewhat, but so far it seems to be within the range of the past few years, while the condition of the U.S. Treasury market has slightly deteriorated after steadily worsening since 2022.

Therefore, despite the market pressure being significantly higher than a week ago, Goldman Sachs' Financial Services Index indicates that so far, there has not been severe market turmoil that would force policymakers to intervene