What is the practical impact of a matrix's condition number?

As you said, this is very problem dependent and it depends on what kind of accuracy in what quantity you actually want.

Often, $A$ and $b$ contain some measured data (problem coefficients, loads, etc.). They have usually a stochastic nature due to the errors in measurements. What they found later was that instead of $\tilde{x}$ being the solution of $Ax=b$, it solved another problem, $\tilde{A}\tilde{x}=\tilde{b}$, with $\tilde{A}$ and $\tilde{b}$, respectively, very close to $A$ and $b$ in terms of the measurements errors. So instead of solving exactly the already inexactly constructed problem, they found that they solved a still-acceptable problem within the measurement error tolerances even though their computed solution could be considered as a garbage with respect to the original one. But when you have inexactly stated problem, does it have a meaning to attempt to solve it exactly (impossible) or to a very high level of accuracy?

This is the concept of the so called backward error where you seek for what data you actually have the exact solution. It is a very popular topic in numerical linear algebra and error analysis and was pioneered by von Neumann, Turing and further developed and popularised by Jim Wilkinson. This appeared to be an important tool for analysing the rounding errors in floating point computations since the backward error analysis allows you to obtain bounds on the forward errors ($x-\tilde{x}$ in some norm) in two separate parts: the algorithm-dependent part (provide bounds on the backward error) and the problem-dependent part (sensitivity of the problem, some sort of condition number).

If the backward error is small enough (by the order of $\epsilon_{\mathrm{mach}}$, you can say that you solved your problem to the greatest accuracy you could hope for on your computer. Why? Because even if you could somehow obtain "exact" values of the entries of your $A$ and $b$, the relative errors due to their storage in the finite precision arithmetic are of the order of the machine precision.

Now what exactly is the backward error in the context of the linear (nonsingular, for simplicity) systems? Assume you want to solve $Ax=b$ and obtain some $\tilde{x}=x+\delta x$. So you look for $\tilde{A}=A+\delta A$ and $\tilde{b}=b+\delta b$ such that $\tilde{A}\tilde{x}=\tilde{b}$, that is, your $\tilde{x}$ is the exact solution of a perturbed problem. Of course, we would like $\delta A$ and $\delta b$ to be as close as possible to the original data. So consider, e.g., the following formulation: $$ \eta(\tilde{x})=\min\{\tau:\;(A+\delta A)\tilde{x}=(b+\delta b),\;\|\delta A\|\leq\tau\|A\|,\;\|\delta b\|\leq\tau\|b\|\}. $$ It can be show that the formula for $\eta$ is actually very simple: $$ \eta(\tilde{x})=\frac{\|b-A\tilde{x}\|}{\|A\|\|\tilde{x}\|+\|b\|}. $$ (This result was obtained some time ago in a paper by Rigal and Gaches.) If you want to have a bound on the forward error, then the following holds: $$ \frac{\|x-\tilde{x}\|}{\|x\|}\leq\frac{\eta(\tilde{x})\kappa(A)}{1-\eta(\tilde{x})\kappa(A)}\left(\frac{\|\delta A\|}{\|A\|}+\frac{\|\delta b\|}{\|b\|}\right) $$ assuming $\eta(\tilde{x})\kappa(A)<1$. Now this bound looks very similar than the one in the question. Note however that the backward error $\eta(\tilde{x})$ can be much lower than what you have as the coefficient by the $\kappa(A)$ in your inequality, that is, the relative residual norm: $$ \eta(\tilde{x})\leq\frac{\|b-A\tilde{x}\|}{\|b\|}. $$ At some point, depending on $A$ and $\tilde{x}$, the backward error $\eta(\tilde{x})$ could be even much lower than the right-hand side in the inequality above. Note that the inequality $\eta(\tilde{x})\kappa(A)<1$ guarantees you that the perturbed system matrix $\tilde{A}$ is nonsingular. In other words, if you'd like to be sure you solved some nearby meaningful problem, you'd like to have $\eta(\tilde{x})$ at least of the order of $1/\kappa(A)$. Also, starting from this point, decreasing $\eta$ by an order of magnitude gives you roughly an additional significant digit in your solution error.

Much more can be said about forward/backward errors, I invite you to have a look on the Higham's book if you want to know more details.

Anyway, if you want to solve $Ax=b$, you need to know that your solution won't be exact no matter what algorithm you use and you always need to ask yourself (or somebody else) what do you expect from your solution and in what terms you want to measure the accuracy. This is sometimes hard to assess even in terms of backward errors since in some cases the classical norms like 2-norm or $\infty$-norm used in rounding error analyses are not exactly what appears in the problem you want to solve.

The typical example of this issue is solving discretised partial differential equations. Often, the forward error norm $\|x-\tilde{x}\|$ nor the residual norm $\|b-A\tilde{x}\|$ have a meaningful role in this context. In practice, one is normally interested in the accuracy in terms of fluxes, that is, the gradients of the discrete solutions. It is not unusual that the errors in fluxes can be much lower than the forward errors in the actual $\tilde{x}$ which has usually the meaning of some coordinates of the discrete functional approximation. Instead of looking at the significant digits of $\tilde{x}$, you want to know whether the error you made by getting $\tilde{x}$ instead of $x$ is somewhat related to the discretisation errors in some proper norm (say, in terms of these gradients). Some sort of accuracy analysis of the algorithms in such a context is, however, still an open, and probably very hard to handle, problem.

Of course, if you really insist that you want to solve $Ax=b$ (even though the exactness of your $A$ and $b$ is at least questionable), you can use some approaches based on arbitrary precision arithmetic. However, this is practical only for some small problems and can be incredibly expensive for larger problems. On some conferences, I saw sometimes people that are working on that (even on, e.g., GPUs) but these kind of solvers are so costly that they're mostly useless for practice. Not mentioning that solving linear problems exactly is at least arguable in any context.

In practice, a matrix with a condition number of $10^{3}$ to $10^{6}$ is not terribly problematic. For linear systems, a good rule of thumb is that you lose a digit of precision due to conditioning for every power of 10 in your condition number. Since double precision is a 15-16 digit representation, a matrix with a condition number in the range of $10^{3}$ to $10^{6}$ isn't considered problematic from the standpoint of numerical calculation with direct methods (LU decomposition, Cholesky, etc.). If you were using iterative methods, these condition numbers would be undesirable because larger condition numbers mean slower convergence, so it would behoove you to use a preconditioner to transform your linear system into an equivalent linear system with smaller condition number to speed convergence. More problematic would be extremely ill-conditioned problems, with condition numbers exceeding $10^{10}$ or so; for these, more numerical precision would be needed, such as quadruple precision, or arbitrary precision arithmetic.

As for propagating the measurement/experimental error through the calculation, the situation you describe can only be remedied through obtaining better data. Consider the case where $\kappa(A) = 1$, and $A$ is known exactly. Then the relative error in your solution is bounded by the relative error in your input data, as indicated by the error bound you cite. This error swamps out the error due to numerics. You can't get a more precise solution via better numerics in that case; you can only get a more precise solution via better, more precise data. In practice, people recognize this limitation, and they do the best they can with the data they have, which is probably why it's not mentioned much in engineering courses. The typical exercise of doing Gaussian elimination in extremely limited precision (say, 3 decimal places) is supposed to emulate the consequences of data with limited precision.