The Bank of Japan has gone a long way in granting the government's wishes in the past months with its firm pledge to end deflation and by loosening policy at a time when the economy has started picking up.

One step it has long refused to take is to buy government bonds with longer maturities under its two-year-old asset buying scheme, but it may now find itself forced to take that very step as soon as next week.

The BOJ's central argument has been that by buying longer-dated debt it could be seen as crossing a line between temporary stimulus in the form of buying bonds to pump more money into the economy, and printing more money to fund government spending, effectively monetising the country's already bloated debt.

That in turn could undermine market confidence in monetary policy, the government's ability and readiness to fix its finances and ultimately the yen currency, the reasoning goes.

But that argument rings hollow for one reason: markets don't seem to care.

On the contrary, most investors and analysts side with politicians and say the BOJ should boost its balance sheet more forcefully to inflate the anaemic economy, weaken the yen and lead Japan out of decade-long deflation.

The BOJ should do more. It should be more aggressive and cause increases in asset prices, says Le Ngoc Nhan, vice president of MorganStanley MUFG in Tokyo.

It shouldn't be worried about inflation because Japan has not escaped deflation.

Another reason why the BOJ has refrained from buying longer term government debt is its concern that it would complicate efforts to withdraw the stimulus when it is needed.

It has a point.

Since its quantitative easing campaign in 2001-2006, the central bank to this day keeps buying large amounts of bonds with various maturities, with purchases of about $260 billion (161 billion pounds) expected this year, because the market and the economy never seemed ready for a tightening that ending the scheme would represent.

But central bankers are in a bind because airing their concerns about stimulus withdrawal today would cast doubt on their commitment to battling deflation.

Huge bond buying is a very unorthodox policy, so it needs to be done carefully, Toshiro Muto, a former deputy BOJ governor considered a leading candidate to succeed Governor Masaaki Shirakawa, told Reuters in an interview in March.

The BOJ shouldn't emphasize the need for an exit policy now because that would give markets an impression it is hesitant of acting boldly. But it always needs to think about an exit strategy.

PSYCHOLOGICAL EFFECT

The implicit pledge to act boldly is what made the central bank's action in February so effective. Markets interpreted its adoption of a 1 percent inflation goal and a 10 trillion yen increase in its government bond buying target under the asset-buying scheme as a commitment to a long easing campaign.

While the BOJ disappointed some traders and politicians by holding fire in March and at its April 9-10 meeting, sources plugged into the BOJ thinking have told Reuters more bond buying will probably be on the cards at its policy meeting next week.

But buying more short-term bonds under the scheme's current two-year time-frame may not do the trick.

Central bankers admit this is less and less effective given that two-year yields have already come down to 0.1 percent. The BOJ may need to start targeting maturities of 5 or even 10 years to dispel doubts about its deflation-fighting credentials.

In order for its policy to have a real effect, the BOJ needs to increase its net government bond holdings, Muto has said, advocating shifting more towards long-term maturities.

Muto represents the line of thinking that the psychological impact of convincing markets that the central bank would do what it takes to cap the yen and bring back some inflation is just as important as direct effects of pumping more cash into the economy.

NEVER FORGET RISKS

Shirakawa and some other officials, however, argue the central bank has already put powerful stimulus in place and worry that benefits of flooding an economy beset by structural problems with more cheap cash may not justify risks involved.

Their worry is that vast government debt holdings on its books, exceeding levels at other major central banks when measured in relation to the size of the economy, will make it tough to tighten policy when it is needed.

That led the BOJ to adopt in 2001 a limit on total bond holdings linking it to the value of banknotes in circulation.

Some economists argue it has effectively abandoned that rule by making an exemption for the asset buying scheme and getting to a point where the BOJ now buys nearly as much government debt in a year, 40 trillion yen, as the government borrows.

For some that means the BOJ is already effectively bankrolling public spending, though technically it would have to underwrite bonds directly to do so.

Markets don't mind because they know the purpose of bond buying is monetary easing, not funding government largesse, says Chotaro Morita, chief rates strategist for Japan at Barclays Capital Japan.

For now the government and the central bank broadly agree on the need for monetary stimulus, but that can change if politicians end up relying on central bank debt buying as a substitute for budget tightening and other reforms.

Structural reforms must be implemented within the breathing space provided by the provision of central bank liquidity, Shirakawa said in a speech in New York this week.

Time bought can equally be usefully spent or wasted.

(Editing by Tomasz Janowski and Kim Coghill)