According to this functional definition, the way we are currently using language models basically excludes understanding. We are asking them to dream up or brainstorm things – to tell us the first things they associate with the prompt.
Maybe it's possible to set up the system with some kind of self-feedback loop, where it continues evaluating and improving its answers without further prompts. If that works, it would be one step closer to a true AGI that can be said to understand things.
There is a lot of confusion around the Chinese Room Argument. I think it makes a valid point by demonstrating that input/output behavior alone is insufficient for evaluating whether a system is intelligent and understands things. In order to do that, we need to see (or assume) the internal mechanism.