ECB President Mario Draghi said on Thursday the bank's policy measures will be reviewed in March after a drop in oil prices and a slowdown in China. Short-term German bond yields fell to record lows and the stock market gained after his remarks.

The dwindling inflation expectations suggest that while financial markets may be rallying, the good mood shows little sign of spreading to the real economy any time soon.

The five-year, five-year breakeven forward, which shows where markets expect 2026 eurozone inflation forecasts to be in 2021 , fell to 1.5621 percent, their lowest since February 2015.

It has fallen almost 25 basis points from a high in early December as falling oil prices drove down inflation expectations.

"That's proof that the ECB, at this stage, is unable to control inflation expectations," said Cyril Regnat, a fixed income strategist at Natixis. But markets were probably over- reacting, he said, and inflation expectations might rise if oil prices recover.

The euro zone could tip into deflation for some months in the first half of the year because of low oil prices, European Central Bank Governing Council member Ewald Nowotny said.

Money markets are pricing in roughly an 80 percent chance the ECB will cut its deposit rate by 10 basis points in March. Analysts also expect the ECB to expand its 60 billion euro a month asset buying programme which it launched in March 2015 and is due to last at least until March 2017.

PERIPHERAL CEILING

Peripheral government bonds saw some relief as the upcoming ECB stimulus offset worries about Italian and Portuguese banks which sent yields in southern Europe to multi-month highs in recent weeks.

The yield on Portugal's 10-year government bond fell 5 basis points at 2.84 percent , down 16 basis points from Thursday's six-month high.

Greek 10-year bond yields fell 56 bps to 9.55 percent . Spanish and Italian yields were still up 1 to 2 basis points at 1.74 percent and 1.58 percent, respectively, although the bonds were outperforming higher-rated Bunds.

"By boosting expectations for further easing, the ECB is providing a ceiling for yields on peripheral bonds, and this is significant," said Lyn Graham-Taylor, a fixed-income strategist at Rabobank.

Expectations of further ECB stimulus also sent yields on two and five-year German bonds to record lows at -0.456 percent and -0.246 percent respectively.

Speaking at the World Economic Forum in Davos on Friday, the ECB's Draghi said the bank had plenty of instruments at its disposal to push inflation higher and was both determined and willing to act to fulfil its mandate.

German Bund yields rose as oil rallied by 5 percent and European stocks <.FTEU3> gained 2 percent gain, weakening demand for safe-haven assets.

The 10-year Bund yield was last up 3 bps at 0.42 percent and above Thursday's 8 1/2-month low of 0.36 percent.

(Additional reporting by Marius Zaharia, editing by Larry King)

By Dhara Ranasinghe