Sales of new homes plunged in August and prices posted their biggest year-on-year drop in nearly 37 years, the U.S. Commerce Department said on Thursday, underlining the depth of problems facing the housing sector.

A separate report from the Labor Department showing new claims for unemployment insurance fell a surprising 15,000 last week to 298,000 implied the drag from housing was not spilling into labor markets. Even so, speculation flared that the Federal Reserve will have to cut interest rates further to counter an economic slowdown.

"For the Fed, the question is whether this is worse than they really expected and whether it might well be a reason for them to do more preemptive easing," economist Pierre Ellis at Decision Economics in New York said of the home sales decline.

Sales of new, single-family homes dropped 8.3 percent last month to an annual rate of 795,000 -- the slowest rate in seven years -- and median prices also were down 8.3 percent to $225,700, the lowest since January 2005.

Not only were the home sales figures worse than the 830,000-a-year pace forecast by analysts but they also largely reflect conditions before mid-August market turmoil set in that has led to stiffer lending standards for future loans.

INVESTORS RATTLED

The bleak home sales rattled investors but stocks still closed higher, with the blue chip Dow Jones industrial average up 34.79 points at 13,912.95 as energy shares rose on higher oil prices. At the same time, bond prices gained on renewed hopes the Fed will follow up a rate cut made last week with more reductions.

A third report from the Commerce Department showed the U.S. economy grew at a downwardly revised but still brisk 3.8 percent annual rate in the second quarter, a pace that analysts do not expect to be sustained in the second half of the year.

The report on gross domestic product was a final revision of second-quarter performance, marked down from a 4 percent growth rate published a month ago because imports were stronger than the government had previously estimated.

The home-sales report was the most striking one of the day for financial market participants, who said the slow drawdown in inventories of unsold homes meant the drag on overall economic activity may be prolonged.

The U.S. central bank cut official interest rates by a half-percentage point on September 18, aiming to forestall some of the impact of a housing-led credit squeeze, which policy-makers fear will take a toll on both U.S. and global expansion.

FINISH THE JOB

"Having moved so sharply already, they're going to want to finish what they've started," Ellis predicted.

The overhang of new homes troubled analysts, who noted that foreclosures are expected to soar in coming months when hundreds of billions of dollars worth of adjustable-rate mortgages reset at higher interest rates.

There were 529,000 new homes for sale in August, a 1.5 percent drop from July. But at August's slower sales pace, it would take 8.2 months to clear that inventory, up from the 7.6 months reported in July.

"When you look at that inventory number, what's being added to that is not only homes that were half completed but also the foreclosures that are out there," said Thomas Leritz, portfolio manager with Argent Capital Management in Clayton, Missouri.

Leritz said builders have cut back and would-be buyers who can no longer qualify for mortgages are being shaken out, but he said it may take another six to 12 months for the process to work out.

The better-than-expected jobless claims data buoyed hopes that any economic slowdown will be moderate and that the recession talk spurred by a drop in employment in August, the first drop in four years, was overdone.

"It suggests the economy is still doing well outside of housing and it suggests that the bad employment news we got in August will not be repeated in September," said economist Gary Thayer of A.G. Edwards & Sons Inc. in St. Louis.

The GDP report showed that companies still were spending to expand plants and add new equipment in the second quarter.

Business investment was revised down to an 11 percent annual growth rate from 11.1 percent estimated a month ago, still far ahead of the first quarter's 2.1 percent rate of increase and the strongest since the first quarter of last year.

(Additional reporting by Patrick Rucker and Nancy Waitz)

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