@babylove – First of all, don’t beat yourself up over this. She asked you a question and you gave her your honest opinion. Just because you don’t like it doesn’t mean she shouldn’t wear it.
It could be that your Mother-in-Law is proud of her granddaughter and wants to be recognized for it.
We don’t all like to stand out in a crowd. And oftentimes senior citizens are seen in some brightly colored get-ups. I think if she wears the color yellow well and it makes her feel good then you should just tell her how nice she looks.