Britain is facing a £35bn economic hit and the risk of a recession this year as the fallout from the Iran war adds to the pressure on Keir Starmer’s government, a leading thinktank has warned.

The National Institute of Economic and Social Research (Niesr) 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.

With households facing a rise in energy costs linked to the Iran war, the chancellor, Rachel Reeves, has said that “nothing is off the table” as the government considers options to provide a targeted and temporary support package.

However, Britain’s oldest independent economic research institute said the government faced a multibillion-pound hole in the public finances amid a worsening inflation shock that would make it harder for Reeves to respond.

David Aikman, the Niesr director, said: “This is a serious blow to the government’s mission to get the UK economy growing again.

“The Middle East conflict has laid bare the fact that the UK remains highly exposed to global energy shocks. Even if hostilities ease rapidly, higher energy prices will leave households poorer, businesses facing higher costs, and the economy materially smaller than we expected only a few months ago.”

In a downbeat assessment on Britain’s prospects as the war unfolds, Niesr downgraded its previous growth forecasts for 2026 by 0.5 percentage points, to 0.9%, and by 0.3 percentage points in 2027, to 1%.

It also warned under an adverse scenario, involving the global oil price hitting $140 a barrel, that Britain would face a much bigger inflation shock than currently anticipated, which would risk plunging the economy into a recession in the second half of this year. A barrel of Brent crude oil was trading at $111 on Tuesday.

Calling this “severe but plausible”, it said such a scenario would risk UK inflation rising above 5%, which it said could force the Bank of England to raise interest rates by the most in a single move – 1.5% – since Black Wednesday in 1992.

Even under its baseline scenario, based on a gradual cooling in global energy prices, it said it expected the Bank to raise interest rates by a quarter point in July to 4%, although it cautioned that a rise in borrowing costs from Threadneedle Street at its next policy meeting on Thursday could not be ruled out.

Financial markets widely expect the Bank to keep interest rates unchanged on Thursday. City traders give an outside probability of a quarter-point rise. Last month the Bank kept rates on hold at 3.75%.

With Labour under pressure in the run-up to a tough round of local elections next week, Niesr said that the economic hit from the Iran war had the potential to add almost £24bn to UK government borrowing by the end of the decade.

This would almost entirely erase Reeves’s headroom against her self-imposed fiscal rules.

Stephen Millard, a Niesr deputy director, said: “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.”

Amid speculation that Starmer could face a leadership challenge after a disappointing set of elections, and as the inflation shock unfolds, the UK’s borrowing costs on the global bond markets have risen sharply.

The yield – in effect the interest rate – on 10-year UK government bonds rose on Tuesday above 5%. The 30-year yield has also risen close to the highest levels since 1998.

Reeves told MPs in the Commons on Tuesday 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,” she said.