* BOJ increases government bond buying by 29 percent
* BOJ says aim is to "smooth market operations"
* BOJ is supporting govt stimulus plan, analysts say
* Bond yields fall after announcement
By Hideyuki Sano
TOKYO, March 18 (Reuters) - The Bank of Japan said it would increase purchases of government bonds by nearly a third this year, supporting government plans for more spending to cushion the worst recession since World War Two.
The central bank, which left interest rates on hold at 0.1 percent on Wednesday, did not directly link the purchases of Japanese government bonds to Prime Minister Taro Aso's plans for new stimulus spending.
But analysts said the move would help keep bonds yields steady, containing borrowing costs as the government adds to a mountain of public debt that already exceeds 150 percent of gross domestic product.
"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 from the government," said Junko Nishioka, chief Japan economist at Royal Bank of Scotland.
"Today's announcement shows the BOJ is doing more than what the markets expected to strengthen monetary easing."
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.
The expansion of debt purchases is another step back towards the quantitative easing policy that the BOJ used to try to revive demand earlier this decade after a property bubble collapsed in the 1990s.
Although quantitative easing barely succeeded, Western central banks are drawing from 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 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 worsening of the economy," said Naomi Hasegawa, senior fixed income strategist at Mitsubishi UFJ Securities.
The Bank of Japan has been reluctant to return to zero rates and quantitative easing, which took years to have any discernible impact and then barely pulled Japan out of a decade of deflation.
YIELDS DOWN
Benchmark 10-year JGB yields edged down 2 basis points to 1.285 percent after the BOJ bond-buying announcement but gave up its gains to a flat 1.300 percent for the day.
Worries about looming supply to pay for government stimulus had pushed yields up from a 3-1/2-year low of 1.155 percent hit in December.
The BOJ said it would buy 12 trillion yen of the JGBs with maturities of one to 10 years, more than half the total of the 21.6 trillion allocated for purchases each year.
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 notes in circulation.
The BOJ right now holds 43.6 trillion yen of JGBs, much less than 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
"The government is mulling huge spending to bolster the economy. But with the BOJ effectively stepping towards monetising debt, bond yields are unlikely to rise much from such risk premium," Nishioka said.
Prime Minister Taro Aso said he would compile another stimulus package on top of a plan announced last year, although he has not revealed the amount of spending involved.
In the last quarter, the Japanese economy sank at its fastest rate since the 1974 oil crisis, shrinking about twice as much as the United States and the euro zone, due to its heavy reliance on exports.
Gross domestic product contracted 3.2 percent in the fourth quarter and economists say a rising pile of unsold goods could signal a similar contraction in January-March. ($1=98.47 Yen, $1=.7130 Pound) (Editing by Dayan Candappa)