* BoE to return 35 bln stg of gilt coupons to government
* Move may help govt meet debt reduction target - economists
* Budget watchdog sees short-term savings, long-term costs
* BoE says move equivalent to 35 bln stg of QE purchases
LONDON, Nov 9 (Reuters) - Britain's cash-strapped government said on Friday it would grab an expected 35 billion pound ($55.9 billion) windfall from the Bank of England's bond-buying programme to reduce short-term borrowing.
BoE Governor Mervyn King said the move equated to a modest loosening of monetary policy, potentially giving a boost to the stagnant economy, and economists said it may help finance minister George Osborne meet his debt reduction targets.
But the government's budget watchdog warned the step would bring longer-term costs once interest rates start to rise, and some analysts said it raised concerns about the central bank's independence and the possible future monetisation of debt - traditionally viewed by economists as a big inflation risk.
Until now, the BoE has kept the interest earned on 375 billion pounds of government debt it has bought since March 2009 under an asset purchase programme aimed at boosting Britain's economy. Those payments will total around 35 billion pounds by next March.
But now the BoE will have to transfer this money and future interest payments back to the government - bringing British practice in line with that in the United States and Japan, which also have central bank asset purchase schemes.
"Holding large amounts of cash (by the BoE) is economically inefficient as it requires the Government to borrow money to fund these ... payments," the finance ministry said, adding that it would use the money saved to reduce public borrowing in the current and future tax years.
Gilt prices rallied on the news as it implies lower bond issuance in the short term, although the head of Britain's debt issuance agency, Robert Stheeman, told Reuters he expected the long-run impact on the market to be "negligible".
On Thursday the BoE's Monetary Policy Committee decided not to conduct further asset purchases, and King said he had told the MPC of the government's plans before they made the decision.
"The Committee views the use of coupon income to reduce the stock of outstanding gilts as having an effect similar to the MPC purchasing gilts of the same value," King said.
The Office for Budget Responsibility warned the move did not represent a free lunch for the government, however, and that the money it received now would be offset by higher costs in future.
"While this change will have a positive impact on the public finances in the short term, it will turn negative as and when monetary policy tightens," the OBR said.
A detailed assessment of how the move affects finance minister Osborne's previously receding chances of meeting politically sensitive debt and deficit goals would appear in the OBR's next forecast update on Dec. 5, the watchdog added.
Without the measure, Osborne would probably have had either to introduce more austerity measures on top of the spending cuts and tax hikes planned to erase a huge budget deficit or scrap at least one of the two fiscal targets.
However, Citi economist Michael Saunders said it may allow the government to meet a goal of putting net debt as a share of the economy on a downward path by 2015.
"The reduction in the debt/GDP ratio may just about be enough for the OBR to project that the government will probably hit its target of a falling debt/GDP ratio in 2015/16, whereas previously that appeared out of reach," he said.
"This transfer is more or less equivalent to extra QE, 35 billion upfront and a further 15 billion pounds or so per year thereafter," Saunders said.
But other strategists cast doubt on whether the move would bring any long-term benefit.
"The words 'smoke and mirrors' are an appropriate epithet," said Marc Ostwald, fixed income strategist at Monument Securities. "It reduces the pressure on Osborne to find more revenue and/or spending cuts in the short-term. It does not actually reduce the structural budget deficit that Osborne is targeting," he added.
Royal Bank of Scotland economist Ross Walker warned the decision raised questions about the BoE's operational independence and the possibility of a future "monetisation", or writing-off, of the BoE's entire holdings of public debt.
"It is a surprise," said Malcolm Barr, an economist at JP Morgan. "Any change to the institutional arrangements around QE has the potential to raise questions about who is really in charge, and what the motivation is."
The opposition Labour Party was also critical, calling the decision an accounting trick that failed to tackle the underlying problem of weak growth in Britain's economy.