The mammalian secondary palate arises by outgrowth from the oral side of the paired maxillary processes flanking the primitive oral cavity. Palatal growth depends on reciprocal interactions between the oral ectoderm and the underlying neural-crest-derived mesenchyme. Previous studies have implicated sonic hedgehog (Shh) as an important epithelial signal for regulating palatal growth. However, the cellular and molecular mechanisms through which Shh regulates palatal development in vivo have not been directly analyzed, due in part to early embryonic lethality of mice lacking Shh or other essential components of the Shh signaling pathway. Using Cre/loxP-mediated tissue-specific inactivation of the smoothened (Smo) gene in the developing palatal mesenchyme, we show that the epithelially expressed Shh signals directly to the palatal mesenchyme to regulate palatal mesenchyme cell proliferation through maintenance of cyclin D1 (Ccnd1) and Ccnd2 expression. Moreover, we show that Shh-Smo signaling specifically regulates the expression of the transcription factors Foxf1a, Foxf2 and Osr2 in the developing palatal mesenchyme. Furthermore, we show that Shh signaling regulates Bmp2, Bmp4 and Fgf10 expression in the developing palatal mesenchyme and that specific inactivation of Smo in the palatal mesenchyme indirectly affects palatal epithelial cell proliferation. Together with previous reports that the mesenchymally expressed Fgf10 signals to the palatal epithelium to regulate Shh mRNA expression and cell proliferation, these data demonstrate that Shh signaling plays a central role in coordinating the reciprocal epithelial-mesenchymal interactions controlling palatal outgrowth.