I don't really agree on scaling down the UI. After all, the iPad's 10" UI is almost identical to the 3.5" iPhone's. I see no issues with using a 5x4 (or even 6x4) grid of icons on a 7" model. Also if the iPhone can manage a keyboard, a 7" tablet surely can too.
That all being said, I still don't believe Apple is planning a 7" model.
It's not just the home screen/keyboard UIs, though, it's the UI of the apps themselves. Many iPhone apps written for a 4" screen don't feel at all right on a 10" iPad screen (though admittedly some do without much tweaking, like the home screen), so lots of apps would need to come in iPhone/Big iPad/Little iPad versions. Of course, at some point, developers don't care enough to tune for each and every size, so you might end up with a decrease in general app quality.
On that note, it'll be interesting to see how Android deals with this. There's certainly a place for 7" tablets... and for 15" tablets, too.
That all being said, I still don't believe Apple is planning a 7" model.