(Corrects paragraph 10 in March 18 story to ... five-year low... from ...3-½ year... low)
* BOJ increases government bond buying by 29 percent
* BOJ says limited room to buy even more bonds
* Move supports govt spending, analysts say
* BOJ moving towards quantitative easing, analysts say
* Bond yields fall after announcement
By Hideyuki Sano
TOKYO, March 18 (Reuters) - The Bank of Japan said it would increase its purchases of government bonds from banks by nearly a third, pumping cash into the economy to help cushion the worst recession since World War Two.
The second expansion of debt buying since December signalled the bank may be edging towards quantitative easing, a policy that Japan tested during a decade of deflation and that is now being studied around the world as a response to the financial crisis.
But the Bank of Japan, which left interest rates on hold at 0.1 percent on Wednesday, said it had little room to keep expanding its bond buying.
BOJ Governor Masaaki Shirakawa added that its decision to buy more bonds was based on market needs and had no link to planned government spending to pull the economy out of recession and what is expected to be a second spell of deflation.
Analysts took that with a pinch of salt.
"The BOJ's decision can be interpreted as an effective monetisation of government debt, although the central bank will never say so because it is independent of the government," said Junko Nishioka, chief Japan economist at Royal Bank of Scotland.
Prime Minister Taro Aso's spending plans would require the government to add to the mountain of public debt, which already exceeds 150 percent of GDP. The BOJ buying of Japanese government bonds would help keep borrowing costs down.
The central bank raised the value of JGBs it would buy to a record 1.8 trillion yen ($18.3 billion) a month from 1.4 trillion yen.
"Today's announcement shows the BOJ is doing more than what the markets expected to strengthen monetary easing," Nishioka said.
BONDS YIELDS FALL
The yield on the benchmark 10-year bond ended flat at 1.300 percent, having fallen as low as 1.285 percent after the BOJ announcement.
Worries about looming supply to pay for government stimulus had pushed yields up from a five-year low of 1.155 percent in December.
The BOJ said it would buy 12 trillion yen of JGBs with maturities of one to 10 years, accounting for more than half of the 21.6 trillion yen it said it would buy each year.
The quantitative easing policy the BOJ used to try to revive demand after a property bubble burst in the 1990s barely succeeded, but Western central banks are drawing on Japan's experience as they grapple with the collapse of the U.S. housing market.
The Bank of England aims to buy 75 billion pounds ($105.2 billion) of British government bonds in three months, and the U.S. Federal Reserve has talked of the possibility of buying Treasuries.
The term quantitative easing in Japan is used specifically to describe the policy that flooded the banking system with cash to revive lending and meet targets for the quantity of money circulating in the economy.
Other central banks use the term more generally to describe a dramatic expansion of their balance sheets through asset purchases that boost money supply, with or without a specific target.
"The BOJ has effectively entered the territory of quantitative easing, and it may eventually shift its policy target towards that and cut interest rates to zero if it tries to further ease financial conditions to cope with the worsening of the economy," said Naomi Hasegawa, senior fixed income strategist at Mitsubishi UFJ Securities.
MONETISING DEBT
The Bank of Japan has been reluctant to return to zero rates and quantitative easing, which took years to have any discernible impact last time it pulled these levers.
There is still some debate among economists about whether it was instrumental in pulling Japan out of deflation.
The BOJ has said it has no intention of monetising government debt and it is not aiming directly at pushing down bond yields. JGB buying is just one of its many market operation tools to provide funds to money markets, it says.
The central bank, not wanting to be seen as a money printing machine for the government, has set an internal rule that its JGB holdings should not exceed the amount of yen notes in circulation.
The BOJ holds 43.6 trillion yen of JGBs, compared with around 76.9 trillion yen notes in circulation.
For a graphic tracking the BOJ's JGB holdings and bank notes, click: https://customers.reuters.com/d/graphics/JP_BOJ0309.gif
"I'm not considering reviewing the bank note rule at all," BOJ Governor Shirakawa told a news conference.
"The rule has two meanings. One is to ensure smooth market operations. The other is to make it clear that it is not meant to support JGB markets nor to help the government's finances."
The prime minister has said he would compile another stimulus package on top of 12 trillion yen in spending announced last year. Although Aso has not revealed the amount, the head of the junior party in the ruling coalition said on Wednesday that Japan needed another 10 trillion in spending.
The Japanese economy shrank 3.2 percent in the fourth quarter, its fastest decline since the 1974 oil crisis and twice as fast as the U.S. and euro zone economies, due to its heavy reliance on exports. ($1=98.47 Yen, $1=.7130 Pound) (Editing by Dayan Candappa)