Efforts to extend the Xbox's capabilities beyond gaming remind me of the long-rumored "HomeStation" set top box/console hybrid that would have been sold as a digital media hub for the living room. The HomeStation never materialized, but many of its rumored features found their way into PCs built around Microsoft's Windows XP Media Center Edition. With this latest Xbox update, it looks like Microsoft may be looking to segment its living room offerings between Media Center Edition PCs and Xbox consoles hopped up with multimedia software.
The Xbox doesn't have the hardware or horsepower to compete with Media Center Edition PCs, but it should have more than enough processing power to act as a Windows Media Player appliance. Adding robust multimedia playback capabilities to the Xbox should only make the console more attractive to potential buyers, and I can't see it hurting sales of any of Microsoft's other products.
Of course, just because Microsoft is only just beginning to scratch the Xbox's potential as a multimedia appliance doesn't mean that others haven't been busy hacking the console. A version of Linux that boots on modified Xboxes has spawned a wave of applications that extend the console's capabilities far beyond mere gaming. However, booting Linux on unmodified Xbox consoles has yet to be perfected, which may keep many Linux-based applications out of the hands of average consumers who have no desire to void their warranties.