When submitting a journal article, can I cite a paper which cited my arxiv preprint?
This depends on what the journal's policies are. But in general (i.e. unless the journal overrides this), there's no requirement that the paper you submit be exactly the same as the paper you put on arXiv. It's often the case that the last round of edits you make prior to publication won't be reflected in the arXiv version, and you could consider the addition of citations to be part of that round of edits.

I have seen citation loops in the past, and nobody raised an eyebrow about them. In fields where posting preprints on arXiv is common, it's well understood that this can happen.