Application passwords not working on localhost?

That error could happen if wp_is_application_passwords_available() returns a false, and the docs says:

By default, Application Passwords is available to all sites using SSL
or to local environments. Use
‘wp_is_application_passwords_available’
to adjust its availability.

So, to enable the Application Passwords:

• Enable SSL on your localhost,

• Or define WP_ENVIRONMENT_TYPE either as a global system variable or constant, and set its value to local:

  // Example when defining it as a constant.
  define( 'WP_ENVIRONMENT_TYPE', 'local' );
  

• Or use the wp_is_application_passwords_available hook like so:

  add_filter( 'wp_is_application_passwords_available', '__return_true' );