Mac OS X will not let applications watch the keyboard when you are in a password field (to prevent hackers getting hold of your passwords). However, the system can sometimes get into a state where it thinks it is permanently in a password fields. There are many possible culprits for this but almost anything that asks for a password could cause the problem (eg, web password fields, web password managers, VPN connections, Mail, Parallels, etc). Quitting the appropriate affected application or restarting will resolve the issue (until it reappears). Terminal has a Secure Keyboard Entry mode, as does Webroot SecureAnywhere by default.
Keyboard Maestro will tell you if it detects the system is in Secure Input Mode and if possible indicate the process which is causing the issue in the Keyboard Maestro status menu or by clicking the yellow warning triangle in the bottom right corner of the Keyboard Maestro editor.
Note that if a background process enables Secure Input Mode then the system may incorrectly attribute the cause to the current foreground process, which will mislead Keyboard Maestro and then you as to which application is responsible (thanks to Smile Software for reporting this!).
Note that there is nothing Keyboard Maestro can do to “work around” Secure Input Mode - it is a system security feature that has been erroneously left on. Keyboard Maestro can detect and report it, but it can no more work around the problem that it could bipass any other security features of Mac OS X.
There is a forum topic on the subject and the Smile Software folks have a very good page on this subject (as it affects TextExpander similarly to Keyboard Maestro) which lists a lot of possible causes, including:
If you continue to have problems, contact support.