German retailer believe shoppers have factored in the VAT rise

The Munich-based institute's business climate index rose to 107.7 in March from 107 in February. The index had declined in the previous two months.

Retailers helped fuel the rebound, saying that the 19% rise in VAT had now been largely factored in by consumers.

The gain may point to an interest rate rise in coming months, analysts said.

'Dampening effect'

"No doubt about it, the Ifo is better than expected," said Ralph Solveen of Commerzbank. "This makes it more likely that the economy will continue to progress well."

As a result, "there is no reason for the European Central Bank (ECB) to change its optimistic view of the economy" and it will continue to raise interest rates, he said.

The ECB's main interest rate is at 3.75% and many analysts are forecasting that it will rise to 4% this summer, helped by steady growth in Germany, Europe's biggest economy.

"The dampening effect of the VAT hike on the economy in the first months of the year appears to be less strong than expected due to strong overall domestic growth," the German Economy Ministry said in a statement.

According to Ifo, business confidence also improved among manufacturers, though construction firms and wholesalers were less optimistic that they had been in February.

"The economic upswing is strong and robust," said Ifo president Hans-Werner Sinn.