The widely watched business climate index, calculated each month by the Munich-based economic research institute Ifo, slipped to 107.9 points in January from the 16-year high of 108.7 points in December.

At the same time, a monthly consumer sentiment index calculated by market research group GfK was forecast to fall to 4.8 points in February from 8.5 points in January.

"The widely predicted deterioration in the consumer climate at the start of the new year has kicked in," GfK found.

"The tax shock and the anticipatory purchases in December had led to a drastic decline in consumers' willingness to spend this month," it explained.

Putting the breaks on household spending

The German government raised sales tax by three full percentage points to 19 percent with effect from Jan. 1, in a move experts said would put the brakes on household spending and therefore on the economy as a whole.

The sharp VAT hike is now also hitting business confidence, the more important Ifo business climate index showed.

After topping a 16-year high in December, index fell surprisingly this month. Analysts had been penciling in a steady to slightly higher reading in January.

But even after the decline, business confidence in Germany remains at its second-highest level since January 1991 and the current upturn is not in jeopardy, Ifo President Hans-Werner Sinn said.

"Companies still reported a very positive current business situation, even if it was not quite so favorable as in the previous month," Sinn said.

A good outlook

Furthermore, companies were more confident with regard to the outlook for the next six months.

"This indicates that after a brief pause, the cyclical recovery will continue in the coming months," Sinn said.

GfK similarly predicted that the dip in consumer sentiment this month would prove only temporary. Income expectations were less pessimistic and economic expectations were continuing to develop positively, GfK noted.

The government insisted that the fundamental upwards trend in the German economy was still intact.

"The dampening effects on private consumption will be overcome quickly," the economy ministry said in a statement. "Household spending would pick up again during the course of the year and contribute to overall growth."

An unbroken uptrend

Analysts, too, insisted that the uptrend in both the German and Eurozone economies remained unbroken.

"The (Ifo) index remains well above the long-term average and is still pointing to above trend growth in the Eurozone," said Bank of America economist Matthew Sharratt.

"The January decline only represents a modest correction. The data are consistent with our expectation that the German economic upswing is likely to take a breather in the first quarter of 2007 but will return to above-trend growth in the second half," Sharratt said.

Raising interest rates?

IXIS economist Sylvain Broyer said the latest Ifo and GfK confidence data, coupled with steady business confidence in France, pointed to a "marked air pocket in activity during the first half of this year, re-accelerating somewhat in the second half."

With inflationary dangers still not completely banished, the European Central Bank will, according to Broyer, "remain hawkish for a while."

NordLB analyst Tobias Basse similarly predicted that the ECB would "stick to its guns and raise its key interest rates by a quarter of percentage point in March."

The guardian of the Euro last raised its benchmark "refi" refinancing rate to a five-year high of 3.50 percent in December, and is expected to continue tightening monetary conditions in the 13 countries that share the euro in the coming months.