Though it hasn't been announced just yet, I believe there will be a smaller form factor Touch out for the back to school rush... nearing the end of the summer.
2.8 inch iPod Touch form-factors have been manufactured and photographed, and since the iPhone was not released with 2 different sizes, it only makes sense that apple is making the touch slightly smaller and more than likely slightly cheaper(maybe $179.00?) than the iPhone.
Even though the iPhone is subsidized from AT&T, consumers won't see the benefit of buying an iPod Touch if it remains more expensive than it's full-featured big brother. Therefore a price-drop is pretty much inevitable, and a hardware update, just as much so.
Look for apple to slowly phase out all click-wheel iPod designs and phase in multi-touch technology where ever possible. Including all models of the iPhone, less the shuffle.