After influenza infection, lineage-negative epithelial progenitors (LNEPs) exhibit a binary response to reconstitute epithelial barriers: activating a Notch-dependent ΔNp63/cytokeratin 5 (Krt5) remodelling program or differentiating into alveolar type II cells (AEC2s). Here we show that local lung hypoxia, through hypoxia-inducible factor (HIF1α), drives Notch signalling and Krt5^pos basal-like cell expansion. Single-cell transcriptional profiling of human AEC2s from fibrotic lungs revealed a hypoxic subpopulation with activated Notch, suppressed surfactant protein C (SPC), and transdifferentiation toward a Krt5^pos basal-like state. Activated murine Krt5^pos LNEPs and diseased human AEC2s upregulate strikingly similar core pathways underlying migration and squamous metaplasia. While robust, HIF1α-driven metaplasia is ultimately inferior to AEC2 reconstitution in restoring normal lung function. HIF1α deletion or enhanced Wnt/β-catenin activity in Sox2^pos LNEPs blocks Notch and Krt5 activation, instead promoting rapid AEC2 differentiation and migration and improving the quality of alveolar repair.