Yes it's very possible. Disk space is not a big issues at the moment. As for the gameslowing down the only two things that would have any impact on game play performance would be weather effects and lighting effects for day-night cycles etc. But if done well then it should be managable and maybe not noticable.
I would add to that, any number of cars smoking out and wrecking, that could cause slowdown, and does in Prologue.
I think the team has a pretty good idea what they can push through the engine, and think it's probably 85-90 percent done. There are some decent performance tools available, and I'm sure Polyphony has their own, which show where they can tweak performance here and there. Keep in mind that the PS3 is similar in power to a pretty potent gaming PC. I'm buying a gaming rig which would undoubtedly smoke it in pixel and poly count, but it's the very latest AMD AM3 chipset with 4 gigs of ram and a GeForce 260 216 core graphics card with another 896MB of ram. It also costs about $1000.

And the games won't be nearly as fun as the ones for the PS3.
While the PS3 is rather cramped in the ram department, keep in mind what Kaz and the lads have already accomplished in Prologue. It's simply stunning. What they're doing now in the full GT5 engine, we can only guess at, and they still have months to polish and tweak it further. The RSX graphics processor is very powerful, and there are seven cores available in the Cell, all running at 3.2ghz, and all freely assignable to different tasks such as bot AI, special effects, physics, any weather or damage, etc. Also keep in mind that Kazunori-dono's team is trying to get as many as 20 cars on track at once in GT5, and they won't do that if the game bogs down. But the fact that they're discussing such a thing seriously indicates to me that the PS3 is a sheer beast, loaded with power and potential, so what will be delivered when GT5 ships will probably be earthshaking.