I've just tested an MD5 password, and it works for me..
However, something does seem to happen after i login using a newly generated password, i'd guess WordPress does something with it, i'm not sure what, but in any case, it still remains MD5 encrypted and login does work correctly.
I tried two ways both via PhpMyAdmin..
Edited a user, plonked in an MD5 string of a newly made password(taken from the result of echo md5('mypassword');, and saved..
Then logged in successfully.
Second approach, editted a user, removing the password, setting the field in phpmyadmin to MD5, typed in mypassword to the right, hit Save(Go in phpmyadmin).
Then logged in successfully.
I can repeat this over and over, MD5 is correct, and it does work.