Signaling by the ureteric bud epithelium is essential for survival, proliferation and differentiation of the metanephric mesenchyme during kidney development. Most studies that have addressed ureteric signaling have focused on the proximal, branching, ureteric epithelium. We demonstrate that sonic hedgehog is expressed in the ureteric epithelium of the distal, non-branching medullary collecting ducts and continues into the epithelium of the ureter -- the urinary outflow tract that connects the kidney with the bladder. Upregulation of patched 1, the sonic hedgehog receptor and a downstream target gene of the signaling pathway in the mesenchyme surrounding the distal collecting ducts and the ureter suggests that sonic hedgehog acts as a paracrine signal. In vivo and in vitro analyses demonstrate that sonic hedgehog promotes mesenchymal cell proliferation, regulates the timing of differentiation of smooth muscle progenitor cells, and sets the pattern of mesenchymal differentiation through its dose-dependent inhibition of smooth muscle formation. In addition, we also show that bone morphogenetic protein 4 is a downstream target gene of sonic hedgehog signaling in kidney stroma and ureteral mesenchyme, but does not mediate the effects of sonic hedgehog in the control of mesenchymal proliferation.