A novel displacement encoder employing a sine micro-window grating is developed. It features high quality signals free from harmonic errors. The sine micro-window grating is a special component composed of arrays of micro-elements with a sine window at the center of each element. The prototype is successfully manufactured by employing optical pattern generator and lithography technology and practically used in the design of an optical encoder. Experiments show that the harmonic errors of encoder signals is reduced to less than 2% of the fundamental wave.