Proper patterning of self-renewing organs, like the hair follicle, requires exquisite regulation of growth signals. Sonic hedgehog (Shh) signaling in skin controls the growth and morphogenesis of hair follicle epithelium in part through regulating the Gli transcription factors. While ectopic induction of Shh target genes leads to hair follicle tumors, such as basal cell carcinomas, how Shh signaling normally functions during the cyclic process of hair development is unknown. Here, we show that, during the hair cycle, Shh expression and the ability of skin cells to respond to Shh signaling is spatially and temporally regulated. Induction of Shh target genes normally occurs only in the anagen hair follicle in response to expression of Shh. However, in patched1 heterozygous mice, putative tumor precursors form with concomitant induction of Shh target gene transcription only during anagen in follicular and interfollicular keratinocytes. Ectopic production of Gli1 accumulates Gli protein and induces Shh target genes and epithelial tumors at anagen but not other stages, pointing to a restricted competence occurring at the level of Gli protein accumulation. Delivery and reception of growth signals among multipotent cells are restricted in time and space to facilitate cyclic pattern formation.