The mammalian pituitary gland originates from two separate germinal tissues during embryonic development. The anterior and intermediate lobes of the pituitary are derived from Rathke's pouch, a pocket formed by an invagination of the oral ectoderm. The posterior lobe is derived from the infundibulum, which is formed by evagination of the neuroectoderm in the ventral diencephalon. Previous studies have shown that development of Rathke's pouch and the generation of distinct populations of hormone-producing endocrine cell lineages in the anterior/intermediate pituitary lobes is regulated by a number of transcription factors expressed in the pouch and by inductive signals from the ventral diencephalon/infundibulum. However, little is known about factors that regulate the development of the posterior pituitary lobe. In this study, we show that the LIM-homeobox gene Lhx2 is extensively expressed in the developing ventral diencephalon, including the infundibulum and the posterior lobe of the pituitary. Deletion of Lhx2 gene results in persistent cell proliferation, a complete failure of evagination of the neuroectoderm in the ventral diencephalon, and defects in the formation of the distinct morphological features of the infundibulum and the posterior pituitary lobe. Rathke's pouch is formed and endocrine cell lineages are generated in the anterior/intermediate pituitary lobes of the Lhx2 mutant. However, the shape and organization of the pouch and the anterior/intermediate pituitary lobes are severely altered due to the defects in development of the infundibulum and the posterior lobe. Our study thus reveals an essential role for Lhx2 in the regulation of posterior pituitary development and suggests a mechanism whereby development of the posterior lobe may affect the development of the anterior and intermediate lobes of the pituitary gland.