The National Institute of Economic and Social Research warned that Britain faces the risk of a recession this year as a result of a £35bn economic hit from fallout of the Iran war. The think tank said that even under a best-case scenario the UK economy would grow at a much slower pace this year and next because of the Middle East conflict.

The institute downgraded its previous growth forecast for 2026 by 0.5 percentage points to 0.9%, and cut its 2027 forecast by 0.3 percentage points to 1%. It said the government faced a multibillion-pound hole in the public finances as the inflation shock worsened, and estimated that the economic hit could add almost £24bn to UK government borrowing by the end of the decade, almost entirely erasing the chancellor's headroom against her self-imposed fiscal rules.

Under an adverse scenario in which the global oil price hits $140 a barrel, Britain would face a much bigger inflation shock and risk slipping into recession in the second half of this year, the institute said. Such a scenario could push UK inflation above 5% and force the Bank of England to raise interest rates by 1.5% in a single move, the largest since Black Wednesday in 1992. A barrel of Brent crude oil was trading at $111 on Tuesday.

"This is a serious blow to the government's mission to get the UK economy growing again," said David Aikman, director of the National Institute of Economic and Social Research. "The Middle East conflict has laid bare the fact that the UK remains highly exposed to global energy shocks," he said. Households face a rise in energy costs linked to the conflict.

Under its baseline scenario, the institute expected the Bank of England to raise interest rates by a quarter point in July to 4%, and said it could not rule out a rise in borrowing costs at the Bank's next policy meeting. Last month the Bank of England kept interest rates on hold at 3.75%.

"Things can be much worse. In a way, the assumption made by financial markets that oil prices have more or less peaked and will come down to $65 per barrel over the next two years looks to be increasingly optimistic. Either way the Bank's monetary policy committee are going to have to raise rates this year, and the chancellor is going to have some very tough calls," said Stephen Millard, deputy director of the institute.

The yield on 10-year UK government bonds rose above 5% on Tuesday, while the yield on 30-year bonds has risen close to its highest level since 1998. The UK's borrowing costs on global bond markets have risen sharply.

Chancellor Rachel Reeves said "Nothing is off the table" as the government considers options to provide a targeted and temporary support package. She told MPs that her focus was on providing targeted support because blanket measures would be costly and risk stoking inflation further. "While people are calling for immediate support, the impacts of the previous government – the untargeted support which cost over £100bn in total – meant that interest rates, inflation and taxes have ended up being higher than they needed to be," Reeves said.