While AMD looks like the more preferable partner for the GPU element, it's unclear where Microsoft can go with its CPU for the Nextbox. An evolution in the form of IBM POWER7 architecture might seem logical: Microsoft really wanted out-of-order execution for the 360, and never got it. POWER7 does provide it, but in its current form it's big, expensive and power-hungry - basically all the things you don't want in a console CPU.
Intel and AMD may seem to be the obvious choices here but the question is really whether either company has the resources available to generate a bespoke CPU design for a new console. As crazy as it may sound, ARM's reduced power CPUs may be a good fit.
An alternative approach for Microsoft may well be to consider where PC gaming will be in a few years time and design around this notion. Right now we're still at the stage where modern architecture with two cores and four threads still manages to run most games really well - anything beyond four cores/eight threads seems like overkill when the silicon budget could be spent on GPU compute shading, opening the door to offloading elements such as AI and physics onto the graphics processor.
The platform holders also face a real issue in terms of sourcing appropriate RAM tech too. The usual convention is that memory increases by eight times between generations, giving us a target of 4GB for the Nextbox. The issue here concerns the format in which cutting-edge RAM is currently delivered. The current best option is GDDR5, which in itself presents three challenges: IO per chip (bits), latency, and cost.
GDDR5 is currently only 32-bits per chip, so you'd need four chips for a 128-bit bus. It can go up to eight banks of memory, but that means a more expensive 256-bit bus – something not typically associated with consoles. Assuming 4GB of RAM is off the table, this also means manufacturers must produce 512MB chips so that the console would have 2GB system RAM on the 128-bit bus. Latency also becomes an issue for the CPU: this might not be so much of an issue if there were enough threads, but it's still not ideal to have so much latency between the CPU and memory. The other option for RAM might be DDR4, but there's little news on when this will become a mainstream proposition.
RAM - and the lack of it - is probably the single biggest gripe developers have about the current generation architecture, but a related issue concerns transfer speeds: how quickly that space is filled with data. The next-gen consoles will be using optical drives, probably faster iterations of the Blu-ray tech currently seen in the PlayStation 3. We'd like to think that Microsoft will not pursue the mandatory install route, so a further challenge would be in streaming data to get players into the game as quickly as possible while still making the most of the extra memory.
This in turn leads us onto another controversial aspect of next-gen technology: onboard storage. Recent rumours suggest that Project Cafe relies on USB and SD card storage, with only 8GB of onboard flash for cache and downloads. Xbox 360 to this day retains two SKUs: one with a small amount of flash, the other with a fairly generous hard drive. Whether this becomes a core component of the machine as it did with PS3 remains to be seen, but developers will certainly be in favour and Microsoft clearly has much more to gain by including a decent hard drive than Nintendo in terms of online resources and services it can make money from.
At the end of the day, the real challenge with the next-gen of consoles comes down to the fact that there are key issues that prevent cutting edge tech being scaled down and fit into a small box. A true generational leap in power presents a range of technical challenges that the boffins have yet to come up with viable solutions for. It also explains quite nicely why Nintendo would concentrate on the controller as the focus for Project Cafe, and why the rumoured hardware specs are seemingly so close to current 360 and PS3 performance. After all, if the true technological advances aren't open to you, a faster GPU alone isn't going to present the kind of mass-market appeal you can build a console around...