In preparation for my interview with Mark Horne for Trinity Talk and my biography Sunday School at Providence on J.R.R. Tolkien, I have been re-visiting some old works and exposing myself to some new ones on the creator of Middle-Earth. Mark Horne discusses in his J.R.R. Tolkien (Christian Encounter Series) how “Hobbits” came to be in the mind of Tolkien:
That summer day, in the midst of the dreary boredom of marking papers, Tolkien did something that changed his life. Working diligently on marking one of many exams, Tolkien came to the bottom of a page in the exam book, expecting more handwriting to read, evaluate, and mark when he turned it over. But the next page was blank. And for some reason he took up his pen and wrote across the blank space, “In a hole in the ground there lived a hobbit.” He had no idea what a “hobbit” was. When he did define a hobbit, it would change the literary world.
Tom Shippey discusses this in his book (Author of the Century or Road to Middle-Earth): “holbytla” is (IIRC) Anglo-Saxon for “hole dweller.”