Exploring the etymology of "hobbit"

Whether the word was invented by Tolkien, or borrowed (if inadvertently) is somewhat complicated, as the Oxford Dictionaries website* explains:

The entry which was actually published and now appears (with the addition of Tolkien’s death date) in the OED (Second Edition) reads:

In the tales of J.R.R. Tolkien (1892-1973): one of an imaginary people, a small variety of the human race, that gave themselves this name (meaning ‘hole-dweller’) but were called by others halflings, since they were half the height of normal men.

Having as far as he knew invented the word, Tolkien provided an imaginary etymology for hobbit, in order to fit the word into the linguistic landscape of Middle-earth. This was a remarkable feat of reverse engineering, not quite like any of his other etymological exploits amongst the tongues of Middle-earth...

The first quotation in the OED entry is the famous first line of The Hobbit: ‘In a hole in the ground there lived a hobbit.’ It is well known that Tolkien scribbled this sentence on an examination paper he was marking in a moment of boredom (Lett. 163). The word is Tolkien’s most famous coinage–if it is indeed a coinage. His letter of September 1970 to the Dictionary department (quoted above) makes it clear that Tolkien was not entirely certain that he had invented the word, but neither he nor anyone else had at this time uncovered any earlier instance...

Then, after Tolkien’s death, an example of the word did turn up, in a long list of ‘supernatural beings’ appearing in the so-called Denham Tracts, compiled by the Yorkshire merchant M. A. Denham (1800 or 1801-1859). Denham was an amateur folklorist who published many books and pamphlets, including twenty Minor Tracts on Folklore (1849-c.1854). The majority of these Tracts were collected in an edition prepared for the Folklore Society in the 1890s, and the word hobbit appears in the second volume (1895) of this edition...

The 1895 version would have been readily available in university libraries accessible to Tolkien (there is a copy in Oxford), and he was interested in folklore. Alternatively, he could have seen a list copied out by one of his friends or colleagues — someone like C. S. Lewis who read all kinds of abstruse writings... Even if Tolkien had in fact picked the word up from the Tract, this would only replace one mystery with another, for we do not know where Denham found the word, or what its meaning and etymology are.

Much more at the link, for the enthusiast.

* citing The Ring of Words: Tolkien and the Oxford English Dictionary by Peter Gilliver, Jeremy Marshall, and Edmund Weiner.