We don't use the hosts file. The settings in IE are stored in the registry keys above. If you don't populate them, and only use the GPO, then they are set for you, but are only in the user profile for the regiistry settings. If you enable the proxy settings to be machine specific, then they get set in the hklm settings.
does that make sense? GPO's are always confusing.
DNS handles the IP/name resolution. not the hosts file. You shouldn't need a hosts file if DNS is working.