Brian, I am a bit perplexed. I make 1/4 round holes with an 1/8 bit all the time. How out of round are your holes? What is the X dim vs the Y dim? What was the design dist?
I have also cut quite a few gears and noticed no eccentricity later when the gears are running. So while the drill option should give you round holes, I am curious as to why our experiences seem so different.
My suspicion is you have some backlash in your rack/pinion for either x or y. As backlash would show up as out of round holes. With the drivers engaged can you move the Z car in either x or y? You might check with a dial indicator and see if any motion corresponds to the amount of eccentricity you are seeing in the holes.
How about some pictures of the elliptical holes so we can compare to our results.
I routinely cut 1/4" pockets with a 1/8 bit and then put die cut parts into them with no visible gaps anywhere, and just a nice snug press fit with my fingers to insert the parts into the pockets.
Most likely you will find the problem and eliminate the drill step.
"The best thing about building something new is either you succeed or learn something. Its a win-win situation."
--Greg Westbrook