Sales of U.S. new homes raced to their highest level in eight months in December, but gains were driven by a surge in the West that economists were reluctant to call a sign of the market's recovery.

Single-family home sales jumped 17.5 percent to a seasonally adjusted 329,000-unit annual rate, the Commerce Department said on Wednesday. Economists had expected an increase to only a 300,000-unit pace.

Even with last month's gain, new-home sales are down 75 percent from their peak of 1.283 million-unit pace in 2005.

December's new-home sales were boosted by a 71.9 percent surge in the West that confounded economists, who viewed the strength as fleeting.

And in a sign that the housing recovery was still a long way off, an industry group on Wednesday reported an 8.7 percent drop in applications for new home loans last week.

The story remains the same. Until we see a stronger recovery in the labor market with a sustained drop in the unemployment rate, I would expect home sales to remain on a lower trajectory, said Michelle Meyer, an economist at Bank of America Merrill Lynch in New York.

But investors said the report was a further sign the U.S. economic recovery was strengthening and broadening. Prices for U.S. government debt fell sharply, and stocks on Wall Street traded higher. The dollar was little changed against the euro.

Federal Reserve officials gave a lukewarm assessment of the economy at the end of a two-day meeting and said the recovery was at a pace insufficient to bring about a significant improvement in labor market conditions.

The U.S. central bank said high unemployment still justified its $600 billion bond-buying program to aid the recovery.

Housing, which was the main trigger of the worst recession since the 1930s, is lagging the broader economy's recovery. Though sales of previously owned homes surged in December, further progress could be frustrated by a glut of homes from an unrelenting wave of foreclosures.

The supply glut, in turn, has been pressuring prices, which have resumed a downward slide and could soon test new lows.

The report by the Mortgage Bankers Association of a fourth straight week of declines in applications for loans to buy homes also suggested housing would remain at depressed levels for some time.

PUZZLING GAIN IN THE WEST

Economists were puzzled by the surge in new-home sales in the West, given that the region has suffered the highest rate of foreclosures. The availability of cut-rate distressed properties would normally draw strength away from the new-homes market.

Clearly the economy in California still faces serious problems, and state and local employees are likely to feel the pain, said Steven Ricchiuto, chief economist at Mizuho Securities in New York.

This suggests that what may be happening in the West is the backlog of foreclosed properties may suddenly be working their way through the course and freeing up sales. I am being very cautious in extrapolating the recent spike in sales to a broader economic recovery in housing.

Others speculated the jump in sales in the West, which was also ravaged by December floods, could have been the result of buyers rushing to take advantage of a statewide homebuyer tax credit.

Contracts for new-homes sales had to be executed before the start of the New Year to qualify for the statewide tax credit, which likely led to a run-up in sales in December, said Daniel Silver, an economist at JPMorgan in New York.

With the spike in sales nationally, the supply of new homes on the market fell to 6.9 months' worth, the lowest since April, from 8.4 months' worth in November.

The median sales price for a new home increased 12.1 percent last month from November to $241,500, the highest since April 2008. Compared with December last year, the median price rose 8.5 percent, the biggest increase since August.

Economists cautioned against reading too much into the rise in prices, saying the gains were tied to the surge in sales in the West.

(Editing by Padraic Cassidy)