There are several techniques used for lettercarving. I have seen people use a chip carving knife; use chisels and gouges to chop down into a letter from its outside edges; and use a router.
Here is another way—a slicing method. The greatest benefit to using this method is you need only one straight chisel and one straight gouge* (with a 3 sweep) to cut virtually any letter, depending on the size of the letter. I have 4 sets of one chisel and one gouge that range in size from 1mm to 20mm. Smaller letters require smaller chisels and gouges; that's why I have 4 sets.
Using a simple sans serif "I" as an example, make stop cuts with a mallet and a vertically-held chisel along the length and in the center of the letter. You do not have to cut very deep and definitely not as deep as the final depth of the letter. Stop cuts do exactly that—they keep your slicing cut from going further across the grain than you intend.
To cut the right side of the letter, the chisel handle is in your right hand while your left hand guides the cut. Switch hands when cutting the left side. If you train yourself to be ambidextrous, you'll save time by not having to continually turn your workpiece around to make a cut.
Bevel up, the cutting edge of the chisel is 45 degrees to your pencil line. Tip the angle of the chisel up, in relation t
o the flat surface of your workpiece, about 20 degrees. Maintaining this compound angle, push the chisel into the wood, but not so far that you cut into the wall of the other side of the letter, and slide the chisel forward along your pencil line. Ideally, it should take two passes with the c
hisel on each side of the letter to pop the center piece out. With the second pass, maintain that compound angle, and ride the back, flat surface of the chisel along the bed of the first cut. You can make sheer, slicing cuts with the chisel if the second pass wasn't perfectly aligned with the first.Cutting the top and bottom of the letter is the same technique—maintain the compound angle and use two passes with the chisel. Clean up the valley created where two walls meet by working in from all sides and into the crevice. Don't be overly picky. One: chances are you'll add stain or paint to your workpiece, which will conceal some errors, and two: it's a good thing for people to know the lettering was carved by hand. Too perfect, and it looks like a machine created it, and it loses its charm (but that's just my opinion).
Use a chisel that is wider than one side of the letter. This way, one corner of the cutting edge is buried in the wood, while the other corner is above the workpiece (and therefore, won't dig into the nice, flat facet you just created). I'll show how to add serifs and cut curves in another post.
*Every once in a while, you may need to buy a gouge with a more pronounced sweep.
The chisel in the photos is a 20mm straight chisel.