updated 6/26/2006 3:59:32 PM ET 2006-06-26T19:59:32

Sales of new homes rose in May to the fastest pace this year, led by big gains in the South.

The Commerce Department reported Monday that sales of new single-family homes increased by 4.6 percent last month to a seasonally adjusted annual rate of 1.234 million units. Wall Street had been expecting a 4 percent drop in sales.

Analysts cautioned against reading too much into the gain, saying the strength in new home sales over the past three months has been heavily related to better-than-normal weather.

The median price of a new home did drop to $235,000 in May, down 4.3 percent from the April sales price. The May level was up 3.1 percent from a median price of $229,200 in May 2005.

But that increase was the smallest year-over-year price gain since the period ending in December 2003.

Analysts pointed to the slowdown in price gains, the reduction in earnings forecasts by some of the nation’s biggest builders and the high level of unsold homes as evidence the housing market is slowing.

“Make no mistake, the home buying market is weakening,” said Bernard Baumohl, executive director of the Economic Outlook Group.

Many economists are looking for sales of both new and existing homes to fall by around 10 percent this year as rising mortgage rates crimp demand. The lowest mortgage rates in four decades helped to propel sales to five straight annual records from 2001 through 2005.

The 4.6 percent increase in sales pushed the sales rate to the highest level since last December and followed increases of 5.9 percent in April and 7.3 percent in March, gains which had followed big declines in January and February.

For May, sales posted the largest increase in the South, a gain of 6 percent which pushed the annual sales rate up to 669,000 units.

Sales rose by 5.3 percent in the West to an annual rate of 317,000 units and were up 2.7 percent in the Midwest to an annual rate of 190,000 units.

The only region to suffer a decline was the Northeast, where sales fell by 7.9 percent to an annual rate of 58,000 units.

The increase in sales in May pushed the number of unsold new homes left on the market at the end of the month down slightly to 556,000 units, down from the all-time high of 560,000 homes for sale at the end of April. It would take 5.5 months to exhaust the current inventory of homes at the May sales pace.

Economists believe that the huge backlog of unsold homes will put more downward pressure on prices in coming months.

Mortgage rates have been climbing steadily this year and rose last week to a nearly four-year high of 6.71 percent, according to a nationwide survey by Freddie Mac.

Many economists believe mortgage rates will continue to rise, approaching 7 percent by the end of the year.

However, they are not forecasting more than a moderate slowdown in housing as long as interest rates do not rise much farther, agreeing with the assessment of Federal Reserve Chairman Ben Bernanke, who recently described the slowdown in housing as an “orderly and moderate” correction.

Toll Brothers Inc., a major builder of luxury homes based in Horsham, Pa., reported last month that orders for homes had fallen by 32 percent in the latest quarter. Last week KB Home, a big Los Angeles builder, announced layoffs of about 7 percent of its work force.

The Fed meets on Wednesday and Thursday and is widely expected to push rates up for a 17th consecutive time with some economists forecasting an 18th rate hike at the August meeting.

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