Network Proxy *.local, 169.254/16 bypass
What is being done there is that you are bypassing any configured proxies for local computers or computers with a self-assigned IP address.  This is configured by default in OS X and has nothing to do with giving your WiFi password to your neighbor.



Local Computers (Hosts)  If you are not given a local DNS name by your DHCP server (your WiFi router, for example), your Mac will default to a .local domain.  So, if you have to go to another computer on your own local network, it will bypass the proxy (if one is configured) and just connect directly.  OS X is assuming all local computers are on the .local domain.

169.254/16  This is a non routable (private) self assigned IP address.  You would get this IP if you don't have a DHCP server providing you one.  Again, this is there to bypass any proxies you might have configured when connecting to a computer on your local network.

What is a Proxy (Server)  In short, a proxy is a server that makes requests as an intermediary for other computes on the network.  For example, you can have a content filter (at work) that prevents you from going to the naughty bits on the Internet.  It will look at your request, analyze it, then either reject it or make the request for one.  When the remote server responds, it takes the data and sends it to you.