Despite what the Fed says, it certainly wants to weaken the US dollar. First, a weaker US dollar makes US-made stuff cheaper overseas, i.e. US exporters benefit. Second, it makes imports more expensive (think oil prices), which is not good for consumers, but makes domestically-made stuff more attractive.
China knows this. So what they do is peg their currency, the yuan, to the US dollar, and occasionally let it float before pegging it again.
Here's how they do it:
The voyage of a dollar (by Jim Fallows)
1) Let's say you buy an Oral-B electric toothbrush for $30 at a CVS in the United States. I choose this example because I've seen a factory in China that probably made the toothbrush. Most of that $30 stays in America, with CVS, the distributors, and Oral-B itself. Eventually $3 or so--an average percentage for small consumer goods--makes its way back to southern China.
2) When the factory originally placed its bid for Oral-B's business, it stated the price in dollars: X million toothbrushes for Y dollars each. But the Chinese manufacturer can't use the dollars directly. It needs RMB--to pay the workers their 1,200-RMB ($160) monthly salary, to buy supplies from other factories in China, to pay its taxes. So it takes the dollars to the local commercial bank--let's say the Shenzhen Development Bank. After showing receipts or waybills to prove that it earned the dollars in genuine trade, not as speculative inflow, the factory trades them for RMB.
3) This is where the first controls kick in. In other major countries, the counterparts to the Shenzhen Development Bank can decide for themselves what to do with the dollars they take in. Trade them for euros or yen on the foreign-exchange market? Invest them directly in America? Issue dollar loans? Whatever they think will bring the highest return. But under China's "surrender requirements," Chinese banks can't do those things. They must treat the dollars, in effect, as contraband, and turn most or all of them (instructions vary from time to time) over to China's equivalent of the Federal Reserve Bank, the People's Bank of China, for RMB at whatever is the official rate of exchange.
With thousands of transactions per day, the dollars pile up like crazy at the PBOC. More precisely, by more than a billion dollars per day. They pile up even faster than the trade surplus with America would indicate, because customers in many other countries settle their accounts in dollars, too.
4) The PBOC must do something with that money, and current Chinese doctrine allows it only one option: to give the dollars to another arm of the central government, the State Administration for Foreign Exchange. It is then SAFE's job to figure out where to park the dollars for the best return: so much in U.S. stocks, so much shifted to euros, and the great majority left in the boring safety of U.S. Treasury notes.
5) And thus our dollar comes back home. Spent at CVS, passed to Oral-B, paid to the factory in southern China, traded for RMB at the Shenzhen bank, "surrendered" to the PBOC, passed to SAFEfor investment, and then bid at auction for Treasury notes, it is ready to be reinjected into the U.S. money supply and spent again--ideally on Chinese-made goods.
China keeping its currency weak leads to inflation problems at home for stuff they import:
Assuming you believe (I definitely do not) the official core (excludes food and energy) inflation rates, if the US didn't pile on debt (and electronically print its own money), inflation rates would be lower. Remember, these are annual rates that have a compounding effect.
