UPDATE 2-Food ban, budget woes put Russian market under cosh
* Russia bans fruit, veg, meat imports from EU, U.S., others
* Moscow's main two share indexes extend sharp falls
* Benchmark govt bond yields hit highest since 2009 (Adds details, comment, updates prices)
By Jason Bush and Polina Devitt
MOSCOW, Aug 7 (Reuters) - Retail and banking shares led broad declines on Russian markets on Thursday after Moscow responded to Western sanctions with food import bans and chose to plug a budget gap by diverting private pension fund contributions.
Prime Minister Dmitry Medvedev said Russia would ban fruit, vegetables, meat, fish, milk and dairy imports from the United States, the European Union, Australia, Canada and Norway for one year starting immediately.
The move was aimed a punishing countries that imposed sanctions on Moscow for annexing Crimea and supporting rebels in eastern Ukraine.
But it looked likely to add to a raft of problems already besetting the Russian economy, and Moscow's main two share indexes extended Wednesday's sharp falls while benchmark government bond yields hit their highest since 2009.
Despite an economic slowdown expected by analysts in a Reuters poll to produce growth of just 0.3 percent this year, the central bank has already hiked interest rates three times in recent months in an attempt to rein in high inflation.
Concerns the ban on Western foods would put further upward pressure on domestic prices were reflected in the share price of leading Russian retailer Magnit, which fell 4.4 percent. Analysts warned that surging inflation could also undermine the basis of the central bank's monetary strategy.
"The ban on food imports ... calls for revisiting the short-term and medium-term inflation outlook, which has deteriorated significantly in recent months," Alfa Bank said in a note to clients.
It hiked its inflation prediction for 2015 to 8 percent - well above the central bank's target.
Medvedev said the food ban "wasn't an easy decision to take", but added that Russia would be able to meet its needs from local production except for milk and beef.
Liza Ermolenko, emerging market economist at Capital Economics in London, described the food ban as "nationalistic policymaking, away from markets and an open economy", adding: "The way things are going now it looks unlikely that the Russian economy is going to grow at all over the next few months."
The negative impact of higher inflation on consumer spending power also ate in to the share prices of financial stocks. They were already facing headwinds from Tuesday's government approval of a plan to use employees' pension fund contributions to plug budget holes for a second year running.
Alexander Baranov, deputy director at Pallada Asset Management, said that was the main factor weighing on markets.
Leading banks Sberbank and VTB were down sharply, falling 2.9 percent and 3.9 percent respectively. The banks were hurt by falling bond prices, which will impact their financial results, Baranov said.
Yields on Russia's ten-year treasury bonds reached 9.87 percent, the highest since late 2009 and a rise of 150 basis points since July.
That was a direct consequence of the government's decision on pensions, which meant the financial system would be short of funds needed to buy bond issues next year, said Baranov.
At 1320 GMT, the dollar-denominated RTS index was down 1.8 percent at 1,140 points, while its rouble-based peer MICEX traded 1.4 percent lower at 1,316 points.
This follows steep falls on Wednesday, when the RTS fell 2.6 percent and MICEX fell 1.7 percent, amid pessimism over the escalating East-West standoff on Ukraine, where fighting between government forces and separatist rebels is continuing.
"The domestic share market remains under selling pressure against the background of strengthening fears of investors regarding a new turn in geopolitical tensions," Promsyvazbank analyst Oleg Shagov said in a note.
The combination of a struggling economy, fiscal juggling and trade restrictions also risks generating fallout among Russian policymakers.
"We may see a total change in the priorities of the central bank and the loss of (its) independence," ING economist Dmitry Polevoy said.
A deputy economy minister, Sergei Belyakov, was sacked on Wednesday for criticising the pension funds decision on Facebook as "stupidity" and "damaging for the economy".
The rouble was initially little changed on Thursday, but subsequently joined the broad Russian sell-off as the day progressed.
The rouble was 0.5 pct weaker against the dollar at 36.36 and down 0.3 percent against the euro at 48.62. It fell 0.4 percent to 41.87 against the dollar-euro basket, its weakest level for three months.
Rossiysky Capital analyst Anastasia Sosnova said in a morning note that the increase in inflation expectations from the import ban would put additional pressure on the rouble.
ING's Polevoy said that food import bans could add around 1.5 percentage points to the annual inflation rate.
The central bank aims to reduce inflation to 4.5 percent in 2015. (Editing by Janet McBride and John Stonestreet)