Government modelling predicts the nation's gross domestic product could be 0.6 per cent lower by 2027 if the conflict isn't resolved soon, Treasurer Jim Chalmers will reveal in a speech on Thursday.
By 2029, in the worst-case scenario, the economy still will not have fully recovered from the aftershocks of the war, Dr Chalmers will say.
"Around half of the impact to GDP is due to the impact of higher oil. The other half is due to broader consequences," he will tell a gathering of business economists in Melbourne.
The war between Iran and the US and Israel has driven oil prices up by 70 per cent since January and pushed up the cost of key commodities such as fuel and fertiliser.
Treasury has been modelling two scenarios for the war - a shorter conflict where oil prices stay about $100 a barrel for the first half of 2026 before gradually declining and a longer one where oil spikes to $120 a barrel, Dr Chalmers will say.
In the longer-term scenario, inflation would peak 1.25 per cent higher than previously expected - around five per cent - while in the shorter-term one it would be at least 0.75 per cent higher, putting it in the high fours in 2026.
That fear prompted Reserve Bank governor Michele Bullock to warn a recession could be a possibility if inflation proves too hard to get down, after the central bank hiked interest rates on Tuesday.
The RBA still hoped to tame inflation without tanking the economy and causing an unnecessarily large spike in unemployment, she said.
"We don't want to have a recession. But if it's hard to get inflation down, then you know, we're going to have to deal with that possibly," Ms Bullock said.
Inflation has been rising in Australia because demand is greater than supply. In central bank jargon, the economy has a positive output gap.
The RBA still believed it could bring that positive output gap down to zero, without taking it negative, Ms Bullock said.
She thinks the bank can lower inflation by gradually taking the heat out of the economy without sending it into a tailspin.
"That's been the approach all along and she was clear in saying that's still the approach," National Australia Bank chief economist Sally Auld told NAB's Morning Call podcast on Wednesday.
"But I guess she did open the door just a crack to a scenario where they might not be successful in that strategy."
With war in the Middle East driving up oil prices and exacerbating inflation pressures, HSBC chief economist Paul Bloxham warned an economic downturn was needed to properly get inflation under control.
Whether that required a recession or just a slowdown in growth depended on how long the RBA could tolerate high inflation, he said.
"The risk is that inflation expectations now start to become unanchored, and that people start to believe that inflation won't actually get back to 2.5 per cent," Mr Bloxham told AAP.
Ms Bullock acknowledged this, saying it was critical inflation expectations stayed anchored.
Already, the bank will be concerned by high-frequency data released by ANZ and Roy Morgan.
Inflation expectations lifted 0.6 percentage points to 6.7 per cent in their latest consumer confidence survey, released on Tuesday.
That's the highest level in more than three years.
Economists at all four big banks still expect a third consecutive rate hike in May.
