The stock market will fall another 26% if the Fed sparks a recession in its fight against inflation, Goldman Sachs says

• The stock market could fall another 26% if the Fed gets too aggressive with its interest rate hikes, according to Goldman Sachs.
• The Fed is expected to raise interest rates next week in its continued bid to tame rising inflation.
• Goldman estimates that an unemployment rate at 6% would send the S&P 500 to 2,900.

The stock market could still have significant downside from current levels if the Federal Reserve gets more aggressive with its interest rate hikes as it attempts to tame rising inflation, according to Goldman Sachs.

The bank said in a Thursday note that it might take a recession to adequately halt rising prices and ultimately squash inflation, and that recession would be sparked by ever higher interest rates. In the case of a Fed-induced recession, investors can expect the S&P 500 to lose over a quarter of its value, the bank said.

Fed Chairman Jerome Powell has already raised interest rates by 225 basis points year-to-date, and is expected to raise rates by another 75 basis points at its FOMC meeting next week, followed by another 100 basis points of interest rate hikes before the end of the year.

The ramp-up in rate hikes comes after August's CPI report once again showed hotter-than-expected inflation, as higher food prices outweighed the recent decline in oil prices and other commodities.

As much as the Fed wants to navigate a soft economic landing via interest rate hikes that subdue demand (and inflation) but barely hurt the labor market, that may not happen.

"A critical debate has emerged between those who think that the current high inflation problem can be resolved without a recession - the GS research central forecast - and those who think a sustained rise in the unemployment rate will be needed. We think both views are legitimately part of the distribution of potential outcomes," Goldman said.

In the most pessimistic view, the Fed needs to significantly hurt the job market to reign in wage growth and tame inflation. In this scenario, Goldman expects the unemployment rate to rise to as high as 6% while the five-year Treasury yield surges to 5.4%.

That scenario would send the S&P 500 to 2,900, representing potential downside of 26% from current levels. The unemployment rate currently stands at 3.7% while the 5-year Treasury yield sits at 3.6%.

Such a decline sparked by more interest rate hikes from the Fed wouldn't be atypical, according to Goldman.

"The cumulative FCI [Financial Conditions Index] tightening and equity declines implied by those estimates for the entire episode would be large by the standard of prior monetary policy-driven corrections, but not unprecedented," Goldman said.

The potential scenario in which the Fed gets more aggressive with its rate hikes signals to investors that as difficult as the year-to-date declines have been in the stock market, they could get a lot worse.

"If only a significant recession — and a sharper Fed response to deliver it — will tame inflation, then the downside to both equities and government bonds could still be substantial, even after the damage that we have already seen," Goldman concluded.