There is a lot of speculation currently about Apple adding a 7 inch iPad to its lineup this fall, as the acclaim for the 7 inch Nexus starts to build. A good overview has been given by John Gruber. The main question would be what place in the line up it should have. It is my conviction that the current iPad is not too large, it would work nearly everywhere, even in a crowded subway car, but that it is simply too heavy to be used one handed. Given how much of its weight is actually in the battery, we know that with improvements in display and processor technology the iPad will come down in weight in the future.
But until this future emerges, it will be much easier to produce a separate device with a smaller screen to get the weight down. To hold a device somewhat comfortably in one hand, it should have a weight of 300 grams, maybe 350 grams. The Nexus 7 is 340 grams, and it is this low weight that makes it stand out. A 7.85 inch iPad has 65% of the area of the current iPad, so would be 394 grams could we simply shrink the iPad 2. But I expect Apple to do their best to reduce the weight even further, and to not include a Retina display until their power consumption comes down enough to keep the entire device below 350 grams.
I also suspect such a device to be cheap, say 250$ for the 16 GByte base, and to replace the iPad 2 in the line up. It will be close enough in functionality that the iPad 2 is no longer needed as a budget option, and the iPad mini is much stronger because it will also be for the people who most value the lesser weight.
The other question is how long we will have to wait until the iPad mini gets a Retina display of similar quality than the current one. This will be an issue because you require such a screen to make the device an excellent reading machine. And the smaller form factor will tend to tilt more towards consumption than creation than a larger iPad. Personally I would recommend to wait until you will get a retina display.