* Dollar set for biggest monthly decline since March 2016
* Yen briefly slips after BOJ resumes medium-tenor bond purchases
* Graphic: World FX rates in 2017 By Saikat Chatterjee
LONDON, Jan 31 (Reuters) - The euro climbed half a percent on Wednesday and was on track for its biggest monthly rise in nearly two years as firm euro zone inflation data for January kept expectations alive for a swift withdrawal of the central bank's stimulus policies.
Though the European Central Bank last week kept policy unchanged and fended off discussions of winding down its massive stimulus programme any time soon, that hasn't prevented some investors from expecting an interest rate hike in the first quarter of 2019.
Underlying inflation, excluding food and energy, - a key measure studied to gauge price pressures in the 19-bloc zone - actually accelerated to 1.2 percent in January from 1.1 percent a month earlier but broader price gauges slowed. "From all accounts, Europe continues to do well, as (is) evident from a strong structural balance, and that has kept investors happy to buy eurozone assets," said Robin Winkler, an FX strategist at Deutsche Bank in London.
European funds have seen more than $22 billion of equity inflows so far in January, after cornering a third of all flows last year across major regions, according to flows data indicating the underlying optimism about the outlook.
Tuesday's preliminary data showed the euro zone economy expanded at its fastest rate in a decade in 2017, with sentiment remaining high at the start of 2018 despite a slight dip from a 17-year peak. Despite the near 4 percent rally in the euro so far this month, the currency remains broadly undervalued on a trade-weighted basis on long-term averages .
On Wednesday, the single currency climbed half a percent to a high of $1.24630 after the inflation data.
STATE OF UNION
Meanwwhile, the dollar fell by a quarter of a percent, putting it on track for its biggest monthly drop in nearly two years as U.S. President Donald Trump's first State of the Union address failed to offer any comfort to ailing dollar bulls.
Against a basket of rivals , the greenback was down 0.25 percent, taking its losses to 3.5 percent in January, its biggest monthly drop since March 2016.
Trump called on the U.S. Congress to pass legislation to ensure at least $1.5 trillion in new infrastructure spending and urged lawmakers to work toward bipartisan compromises, but he pushed a hard line on immigration. The new round of weakness comes after a period of consolidation earlier this week as financial markets expected the U.S. Federal Reserve to take a more confident stance about the outlook of the economy but keep policy unchanged.
"We are still seeing a broad round of dollar weakness and that may be also be because of an undertone of risk aversion in the markets," said Commerzbank currency strategist Esther Reichelt, in Frankfurt.
A market gauge of risk perked up to its highest levels since August 2017 and has nearly doubled this month.
The dollar's weakness also coincided with a time when global growth has picked up across the world, especially in the eurozone and Japan. For a series of charts on the dollar, see The dollar's woes are in sharp contrast to the general mood of optimism with investor flows data painting an upbeat picture.
The yen slipped briefly after the Bank of Japan increased its buying of medium-term Japanese government bonds (JGBs) in a move seen as a warning shot against further rises in bond yields. The dollar reached its intraday high of 109.095 yen shortly after the BOJ announcement. The dollar later pared its gains and was last trading at 108.68 yen , steady on the day.
The BOJ's move came after the 10-year JGB yield had risen to a 6-1/2-month high of 0.095 percent on Tuesday. The central bank's policy guidance is to control the 10-year yield "around zero percent".
BOJ officials have said that any changes to bond-buying operations are fine-tuning and are not meant to telegraph hints on policy.
For Reuters Live Markets blog on European and UK stock markets see reuters://realtime/verb=Open/url= <^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ euro valuations ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>(Reporting by Saikat Chatterjee; Additional reporting by Masayuki Kitano in SINGAPORE; Graphic by Ritvik Carvalho; Editing by Gareth Jones)
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