Thanks everyone for the quick response.

the encoder has only single outputs per channel so is a push-pull type.

Was experimenting this morning. Disconnected the microcontroller from the encoder and operated the motor without feedback. There was no disturbance of the micro's operation, indicating that radiated noise can probably be eliminated as the problem.

Then found that if i hold the wire that is connected to encoder's casing (that was unconnected previously) the system worked perfectly. I am wondering whether the motor is incorrectly grounded or i should physically connect the encoder casing to ground?