Smaller tablets have been totally ignored until the Kindle Fire came along...and the Fire is a huge hit....
... but... um, it's a hit and a success in the 7" category because it's... oh, $199!
The smaller Galaxy Tab is no threat (not the larger 10.1 Samsung is crying about <hello, no one wants your tablet anyway>). It's price... coo coo! And so would a smaller iPads be.
When Steve Jobs claimed they'd never do a 7 incher, I chalked it up to all the other things he said never to (only to do them as little as weeks later in some cases), so I don't doubt this has been in the pipe and isn't do doubt it's in response to any competitive threat. (Digi Times is worthless, but this one's been out there for awhile from more credible sources.)
Sell any tablet with a decent spec set under the hood for $199, and yes, people will buy it. Does anyone see Apple selling a smaller iPad for $199? (Maybe if you are a meth addict, but your opinion doesn't count.) They'd probably do a Samsung and knock $50 off the 10" price and call it a day. Few people are going to see value in saving $50 for a smaller screen when it's on display side by side with the 10".
While I stick to my guns that that 7-8" size is a commercial failure when not priced so low ala The Fire... there are "some" people who would like that size. I guess it's better to snag the minority than give them and an echo system or purchasing away to a competitor. It still wouldn't be a competitor to the Kindle Fire though. I also think Apple is perfectly fine without it.