New home sales in the U.S. fell 2.5% to a seasonally adjusted, annualized pace of 512,000 in May, with sales in the Western U.S. plunging to a 26-year low, the U.S. Commerce Department announced Wednesday (pdf).

Economists surveyed by Bloomberg News had expected May new home sales to register a 515,000 annualized rate.

Sales are still down about 40% compared to a year ago. In 2007, 776,000 new homes were sold, compared to 1.05 million in 2006.

Meanwhile, inventories rose to a 10.9-month supply in May at the current sales pace, compared to a 10.6-month supply in April. A typical, healthy housing market has a three to four month supply of homes for sale.

Sales fell in three regions: 11.6% in the West, 7.9% in the Northeast, and 5.1% in the Midwest. Sales rose a scant 0.4% in the South. Further, the West's 114,000 annualized sales pace was that region's slowest sales pace in 26 years.

Also, the median sales price for a new house decreased 5.7% to $231,000 in May compared to a year ago.

Tough time in California

Economist Peter Dawson said the May new home sales report is more bad news for the U.S. housing sector, particularly for residents of the Golden State.

"It's a rough time to be selling a home in California, no question. The May data shows the housing sector has not bottomed, with more sales and price declines likely for the nation, and California and the West looks particularly rough," Dawson said. "California, like Florida, suffered from overbuilding during the housing boom and the data shows that the market is correcting for that excess to the upside."

Dawson added that the rise in already-high inventories -- to a 10.9-month supply -- is also a bad sign for housing and the U.S. economy. "There's almost no way median home prices can recover until inventories drop to lower levels," Dawson said. "That surplus also discourages new construction, which further delays the economic stimulus that would occur from that new construction."

Many economists and analysts expect new home sales to continue to decline through the end of 2008, as home builders reduce construction, due to anemic U.S. economic growth, sluggish new household formation, and more rigorous mortgage approval requirements.