I think there is enough interest in the 7" iPad to warrant production. Just as the iPod Touch and Nano models have customer bases, it should be the same with the 7". When will be the issue. If enough good 7" competitors are introduced, it will a given. Since Apple likes to be the first out, they may have something this spring. The big question is what will go away because of the smaller size.
I read something the other day( another rumor perhaps?) that Apple was considering abandoning the 9.7" size entirely and going with 7" for Ipad 2. One such reason was to avoid cannibalizing their macbook sales( consider the number of people on here and other apple-centric forums that have opted for an ipad in place of a macbook, hell I'm considering doing that myself).
Assuming there's any truth behind that, wouldn't the 7" pad potentially cannibalize the Ipod touch sales? Especially considering that 1) a 7" inch pad isn't much more portable than the current size. Neither one fits in your pocket, if you're talking portability, and 2) it was mentioned that the price would be lower than the current Ipad. Which would bring it into the ipod touch price range. Unless they drop the price of the touch line across the board, I can't see anyone buying a Touch if an Ipad is priced right around the corner, unless they 'really' need a pocket size device. Speaking strictly in value for dollar though, who would buy a touch over a Pad if they're fairly close in price, taking into account the various models depending on storage size, of course.