Current epidemics of diabetes mellitus is largely caused by wide spread obesity. The best-established connection between obesity and insulin resistance is the elevated and/or dysregulated levels of circulating free fatty acids that cause and aggravate insulin resistance, type 2 diabetes, cardiovascular disease and other hazardous metabolic conditions. Here, we investigated the effect of a major dietary saturated fatty acid, palmitate, on the insulin-sensitizing adipokine adiponectin produced by cultured adipocytes. We have found that palmitate rapidly inhibits transcription of the adiponectin gene and the release of adiponectin from adipocytes. Adiponectin gene expression is controlled primarily by PPARγ and C/EBPα. Using mouse embryonic fibroblasts from C/EBPα-null mice, we have determined that the latter transcription factor may not solely mediate the inhibitory effect of palmitate on adiponectin transcription leaving PPARγ as a likely target of palmitate. In agreement with this model, palmitate increases phosphorylation of PPARγ on Ser273, and substitution of PPARγ for the unphosphorylated mutant Ser273Ala blocks the effect of palmitate on adiponectin transcription. The inhibitory effect of palmitate on adiponectin gene expression requires its intracellular metabolism via the acyl-CoA synthetase 1-mediated pathway. In addition, we found that palmitate stimulates degradation of intracellular adiponectin by lysosomes, and the lysosomal inhibitor, chloroquine, suppressed the effect of palmitate on adiponectin release from adipocytes. We present evidence suggesting that the intracellular sorting receptor, sortilin, plays an important role in targeting of adiponectin to lysosomes. Thus, palmitate not only decreases adiponectin expression at the level of transcription but may also stimulate lysosomal degradation of newly synthesized adiponectin.