Pick a fight with the merchant, but use the steal command to automatically equip his clothes. The child will now let you through.
Exit to the north to access the next part of the city where NPCs in the weapon and armor shop explain the mechanic to you explicitly, telling you to use it on green soldiers. The green soldier can be found by going upstairs by the newly unlocked shop and then all the way behind it.
Now you can advance to the pub, where a bunch of soldiers roam about the place. Go downstairs with the stairs to the right t find a merchant with the wine. Fight him and use steal to change back into a merchant. Walk back to the house and the man finally speaks about the secret passage and the mystery draft. You need to talk to his son — the NPC that only likes merchants — and tell him the password. Of course he doesn't remember the password.
The child gives you three options, picking the wrong one gets you beaten up by a kid, stripped of your disguise and sent back to the start, understandable given that you're only a level thirteen or so thief. The correct choice for me was Courage, rather than Frustration or Wild Rose; if the options differ for you then the correct password is likely different too.
The secret passage that opens up gets you to a dead end (?): the empire HQ/the traitor's house. You'll notice that no music plays in this area, but if you walk upstairs to the traitor's room you'll finally hear the
Chrono Trigger snowstorm loop draft. The drawer in this room is not against the wall so walk behind it for the secret-er passage.
Keep the disguise. Do your thievery stuff in the first room, save in the second and walk around the clockwork in the third. Back in the traitor house, the traitor's daughter told you to wind the clock. Wind the clock in the back of this room to uncover the exit.
Fight your way through the maze. You'll hit a dead end when you'll reach two closed chests and an open one. Backtrack a couple rooms and hug the bottom wall until you find the secretest passage, which eventually lead back full circle to the mystery meat set of staircases foreshadowed at the very start.
Leave the city and head north for a free, well earned rest and then it's guess-where-you-need-to-go time! The answer is west, going backwards through caves you've already explored. You'll meet a "boss" at the end, but if you've set the battle selection mode to memory (a bad idea generally), you can heed the on screen instructions for the first turn and then just hold A throughout. And with that it's back to the story arc selection screen.