The yield of the bond significantly affects monetary policy. These policies can come from the actions of the Central Bank, like the Federal reserve system, currency Board or other types of regulators.
However, monetary policy is essentially about the determination of interest rates. In turn, interest rates determine the risk-free rate of return. The risk-free rate of return has a big impact on the demand for all types of securities, including bonds.
The impact of monetary policy on Bond yields
When interest rates are low, bond yields will decrease due to the increase in demand for bonds. For example, if the yield on bonds is 5%, so the yield becomes more attractive as the risk-free interest rate falls from 3% to 1%. This increased the demand for bonds is accompanied by higher prices and falling yields.
Of course, the reverse is also true. When the risk-free rate of return increases, money moves from financial assets to the security of a guaranteed profit. For example, if the risk-free rate of return increases from 2% to 4%, a bond that gives 5% will become less attractive. Additional yield would not be worth to take the risk. Demand for bonds will decrease and yields will rise, until supply and demand reached a new equilibrium.
Central banks are aware of their ability to influence asset prices through monetary policy. They often use this power to moderate swings in the economy. During the recession, they look to stem deflationary forces due to the decrease in interest rates leads to higher asset prices.
The increase in the prices of assets have a moderately stimulating effect on the economy. When bond yields decrease, this will lead to lower borrowing costs for corporations and governments — leads to an increase in costs. Mortgage rates may also reduce demand for housing will also likely increase.