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The National Association of Realtors reported that the annual sales pace in December reached 4.6 million homes, up 5% from November's pace and 3.6% from a year ago.

It was the third straight month of improvement in the pace of sales. The fourth-quarter sales volume lifted full-year sales to 4.26 million homes, up 1.7% from 2010 levels.

"The pattern of home sales in recent months demonstrates a market in recovery," said Lawrence Yun, the group's chief economist. "Record low mortgage interest rates, job growth and bargain home prices are giving more consumers the confidence they need to enter the market."

Home prices, however, remained depressed, largely because distressed sales continue to make up a significant part of the market.

The median price was $164,500 in December, down 2.5% from a year ago. For the full year, the median price of $166,100 was off 3.9% from 2010 levels.

Realtors said foreclosed homes sold for an average discount of 22% below market value in December, compared to a 20% discount a year ago. Meanwhile, short sales, which are homes sold for less than the amount owed on a mortgage, sold for a 13% discount, compared to a 16% discount in December 2010.

Foreclosures made up 21% of all sales, while short sales were 12%. Both figures were comparable to 2010.

But even with the distressed properties on the market, the inventory of homes for sale has gotten tight.

Realtors calculate that at the current sales pace, there is only a 6.2 month supply of homes available for sale, the smallest since March 2005, before the housing bubble burst.

That was down from a 7.2-month supply in November and more than an 8-month supply a year ago, which is a "a notable decline," according to Troy Davig, an economist with Barclays Capital.

"The housing market appears to be making progress in terms of working through its excess inventory," said Davig in a note Friday.

Joseph LaVorgna, chief U.S. economist for Deutsche Bank, said the current conditions should lead to improved prices and sales in the near term.

Other encouraging signs include a survey of home builders that showed the most bullish view of current sales conditions and customer traffic in nearly five years. The government's report on home building is also showing improvement.

"Coming on the back of a dramatic improvement in homebuilders' sentiment, the latest existing-home sales report corroborates our thesis that a housing recovery has finally begun," LaVorgna wrote in a note.

By Chris Isidore@CNNMoney