Using conditional gene targeting in mice, we show that BMP receptor IA is essential for the differentiation of progenitor cells of the inner root sheath and hair shaft. Without BMPRIA activation, GATA-3 is down-regulated and its regulated control of IRS differentiation is compromised. In contrast, Lef1 is up-regulated, but its regulated control of hair differentiation is still blocked, and BMPRIA-null follicles fail to activate Lef1/β-catenin–regulated genes, including keratin genes. Wnt-mediated transcriptional activation can be restored by transfecting BMPRIA-null keratinocytes with a constitutively activated β-catenin. This places the block downstream from Lef1 expression but upstream from β-catenin stabilization. Because mice lacking the BMP inhibitor Noggin fail to express Lef1, our findings support a model, whereby a sequential inhibition and then activation of BMPRIA is necessary to define a band of hair progenitor cells, which possess enough Lef1 and stabilized β-catenin to activate the hair specific keratin genes and generate the hair shaft.