Think. The writer has mentioned clouds and a moon in the sky. The grey clouds have broken apart revealing the moon above the hills. Of the items mentioned, clouds moving apart and moon in the sky (flying) and the hills (on the ground (not flying), which of these three nouns could possibly be called "flying rags"? Only the clouds are (a) flying and (b) plural (rags). Therefore, the flying clouds must be the flying rags the author is referring to.

A rag is piece of old cloth, often used for cleaning, and which may have an irregular shape, especially if it has been taken from an old piece of clothing. The author is describing the irregular shapes of the clouds as like individual rags.