You must first place your image(s) in the Store Operations/Pictures folder before they can be selected in Label Designer. Selecting images outside of this folder will result in an Error Box being shown on screen.
Label Designer can read any image file type including JPEG, GIF, and BMP in black or white, greyscale or color. There is limitation based on pixel size and color depth, but this varies by image.
If you are having a problem with an image try resizing it using an image editing software like MS Paint, Paintshop Pro, etc.
It's always best to optimize your image size and resolution depending on the printer you will be using to print labels.