* ECB drops easing bias
* But signals inflation caution, reactive policy
* Euro volatile, bank stocks up (updates throughout)
LONDON, March 8 (Reuters) - The euro fell and bond yields in southern Europe hit multi-week lows on Thursday, after the ECB dropped a pledge to boost bond buying if needed but suggested subdued inflation would ensure a slow route back to policy normalisation.
European shares rose to one-week highs, led by banks, which tend to benefit from tighter monetary policy prospects.
While the ECB took a small step towards weaning the euro zone economy off protracted stimulus by dropping its easing bias, ECB President Mario Draghi said monetary policy would remain "reactive" and that underlying inflation was subdued.
That prompted the euro to give up the gains it posted after the ECB's post-meeting statement, while the lack of any signals of broader changes to the policy stance also pushed bond yields in Germany and France off two-week highs.
"They toned down the easing bias but there is still a willingness to ease and the tone of Draghi's comments was still dovish, stressing that there is still not a convincing uptrend in inflation," said Chris Scicluna, head of economic research at Daiwa Capital Markets.
"He also talked about the impact a trade war could have... He is a dove and it's clear he still wears the trousers on the Governing Council."
Keeping broader policy unchanged, the ECB said it could still extend its 2.55 trillion euro ($3.16 trillion) bond purchase scheme beyond September if needed.
But it omitted a reference to bigger purchases, a signal that it remains on track to end its three-year-old stimulus scheme before the end of 2018.
The euro fell 0.2 percent to $1.2390 following Draghi's comments, after climbing to a session high of $1.2446 soon after the policy decision.
German and French five-year bond yields came off two-week highs. Germany's was trading just 1 basis points higher at 0.05 percent, below 2-week highs at 0.097 percent.
Southern European debt, also sensitive to changes in ECB monetary policy, saw a strong rally, benefiting from Draghi's dovish line.
Portugal's 10-year bond yield fell to a six-week low at 1.81 percent, while Spanish 10-year bond yields hit a one-month low at 1.41 percent. Italian 10-year bond yields dropped below 2 percent and are back at pre-election levels.
The pan-European STOXX 600 hit a fresh session high as Draghi spoke, up almost 1 percent, while euro zone stocks were also at a session high, up 0.6 percent. The financials sector was the biggest gainer.
Banking stocks rallied 1.15 percent, while the bank-heavy Italian FTSE MIB index was up 1.2 percent.
Having bought bonds for three years to depress borrowing costs, the ECB said it could still extend the purchases beyond September if needed but omitted a long-standing reference to increasing them - seen as a precursor to a broader policy revision later this year.
"The dropping of the easing bias is consistent with recent political and economic developments," said Antje Praefcke, a currency strategist at Commerzbank in Frankfurt.
(Reporting by Tommy Wilkes, Abhinav Ramnarayan, Fanny Potkin, Danilo Masoni, Saikat Chatterjee and Dhara Ranasinghe; editing by John Stonestreet)