Munich-based Ifo said on Tuesday the index rose to 98.7 from 96.0, powered by a sharp improvement in firms' assessment of both current conditions and expectations for the next six months. The result beat all the forecasts in a Reuters poll of 47 economists, which ranged from 95.0 to 96.7.
"These are fantastic numbers. I'm almost speechless," said Andreas Scheuerle of Dekabank.
A sub-component measuring firms' assessment of current conditions jumped to 98.9, the highest level since February 2001, from 96.5. A measure of business expectations rose to 98.5, the top level since March 2004, from 95.5.
A breakdown showed a strong improvement in all sectors surveyed by Ifo, with retailing sentiment rising sharply. "The economic recovery seems to be on firmer ground," Ifo said in a statement.
Germany's economy ministry said it appeared a weak patch in the second quarter had been overcome. "The economic recovery has set in and will continue in the second half," it said. Indicators have given a mixed picture of the economic outlook in recent weeks.
The government last week trimmed its forecast for growth this year to 0.8 percent from 1.0 percent and lowered its 2006 projection to 1.2 percent from 1.6 percent, in line with the view of the country's leading think tanks, including Ifo.
The mid-range forecast of a Reuters poll of private-sector economists published on Tuesday was for Europe's largest economy to grow 1.3 percent next year, down from 1.5 percent in a similar poll in July.
German retailing organisation HDE said earlier this month that September was the worst month for sales in a very long time, although new car registrations rose strongly.
Germany's BDI industry federation repeated its forecast on Tuesday that the economy could grow up to 1.5 percent next year, but said that depended on the new government sending the right signals on economic and tax reform.